DOES FINANCING DIVERSIFICATION IMPROVE BANK RISK? EVIDENCE FROM INDONESIAN ISLAMIC RURAL BANKS

Abstract

Islamic banks encounter greater loan or financing risks compared to conventional banks due to profit and loss sharing financing (PLS), which is susceptible to asymmetric information and moral hazards. The non-performing financing (NPF) of Islamic rural banks (IRBs) in Indonesia is looked at in this study. It uses bank-specific variables as control variables and looks at what happens when financing portfolios are diversified. We analysed a sample of 100 IBRs from the years 2017 to 2020, utilising quarterly data. We utilised dynamic panel regression with a two-step GMM method in our study. Our research suggests that a high level of financing concentration has a negative impact on non-performing loans. Bank stability has a negative impact on NPF, while bank capital and low-cost efficiency have a positive impact on NPF. Focusing on financing is an effective strategy for decreasing NPF in major investment banks, while diversifying financing is a more prominent strategy for decreasing NPF in small investment banks. In addition, larger IRBs benefit from their efficient management, which helps reduce non-performance fees. Moreover, the cost efficiency of both large and small IRBs contributes to an increase in non-performance fees. This study provides several recommendations that have practical and policy implications. Initially, IBRs adopt a financing concentration strategy to minimise their NPF. Additionally, there is a need for IRBs to enhance their cost efficiency to mitigate potential financial risks.