Equity Financing and Islamic Banks’ Profitability: Evidence from the Biggest Muslim Country

Abstract

It was highlighted in the literature that Islamic banks’ equity financing was very risky in practice. Theoretically, equity financing could boost Islamic banks’profitability because the riskier financial instrument was always associated with the greater return that could be created. Using a sample of nine Islamic banks in Indonesia from 2009m1 to 2014m12, interestingly we found that higher proportion of equity financing was significantly associated with lower Islamic banks’ profitability. However, this negative relationship diminished in the case of large Islamic banks, implying that the negative effect of equity financing on Islamic banks’ profitability was more prominent for small banks rather than for large banks. Our results were robust using various estimations. Although equity financing was a core of Islamic banks and could differ Islamic from conventional banks’ activities but Islamic banks altogether with policymakers should evaluate this instrument for the sake of Islamic banks’ profitability and its prospects in the future.

Keywords

• Equity Financing
• Islamic Banks
• Profitability