Assets Quality and Capital as Risk and Proﬁtability Determinants in

Banking Industry

Ifdah Faizah

and Dian Imanina Burhany

Post Graduate Program of Islamic Finance and Banking, State Polytechnic of Bandung, Indonesia

Keywords:

banking industry, asset quality, capital, risk, proﬁtability.

Abstract:

Assets quality and capital in Indonesian banking industry have increased every year. However, this increase is

not accompanied by an increase in proﬁtability. Although the determinant of unstable proﬁtability is not easy

to predict, the quality of assets and capital are two important components in the ongoing business of banks

to deal with credit risk and to increase proﬁtability, both in conventional and Islamic banks. This study was

conducted to determine whether assets quality and capital have an effect on credit risk and proﬁtability in both

conventional and Islamic banks in Indonesia. The population of this study was 115 banks in Indonesia. The

research used purposive sampling technique and obtained 39 banks as samples, consisting of 29 conventional

banks and 10 Islamic banks. The data were analyzed using path analysis technique. The results show that

assets quality has a positive and signiﬁcant effect on credit risk in both conventional and Islamic banks. On

the other hand, capital has no effect on credit risk in both types of banks. Assets quality has a positive and

signiﬁcant effect on proﬁtability in conventional banks, but has a negative effect on Islamic banks. Capital has

a positive and signiﬁcant effect on proﬁtability in conventional banks. Meanwhile, credit risk has a negative

and signiﬁcant effect on proﬁtability in both banks.

1 INTRODUCTION

The banking industry in Indonesia uses dual bank-

ing system, which are conventional banks and Is-

lamic ones. Indonesian banking industry gradually

grows year by year. As of December 2017 there were

102 conventional banks and 13 Islamic banks with

a total of 32,285 ofﬁces spread throughout Indone-

sia (Keuangan, 2017). The growth in the number of

banks and ofﬁces has a positive impact on the per-

formance of banks in providing ﬁnancial services to

public and inﬂuencingthe growth of their assets and

capital. Total assets and capital in both conventional

and Islamic banks have increased every year. How-

ever, there is still a large gap in total assets and capital

between these two kinds of banks.

Maintaining the assets quality of a bank is very

important to keep the continuity of its business. Based

on the Indonesian Banking Booklet, in order to main-

tain its business, a bank must manage credit risk expo-

sure at an adequate level, among others, by maintain-

ing the assets quality (Keuangan, 2016). Similarly, in

running its business as an intermediary, a bank must

always be prepared to face the risk of loss. With the

existing capital, the bank will be able to absorb losses

that may arise in the future (Siamat, 2005). In ad-

dition, adequate amount of bank capital is needed to

improve resilience and efﬁciency in the recovery pe-

riod due to banking crisis (Latumaerissa, 1999).

As an intermediary, the conventional and Islamic

banks still rely on credit or ﬁnancing as the main in-

come in running their businesses. Distributing credit

is their most important activity in generating proﬁts,

but the biggest risk in banks also comes from the pro-

vision of credit (Firmansyah, 2014). Credit risk is one

of the bank’s business risks resulting from uncertainty

in the return or the non-repayment of credit given

by the bank to the debtor (Siahaan and Asandimitra,

2018). High credit risk will worsen the quality of the

bank credit, which will increase the number of non-

performing loans and cause losses.

Both conventional and Islamic banks are estab-

lished to make proﬁt. The amount of proﬁt is one

of the important things for the banking industry. The

role of banks as intermediary institutions requires

them to maintain investors’ trust, whose funds are

managed by the banks (Indonesia, 2013). Proﬁtabil-

ity is one of the most appropriate indicators to mea-

sure the performance of a company because the higher

the proﬁt generated, the better the company’s ﬁnan-

198

Faizah, I. and Burhany, D.

Assets Quality and Capital as Risk and Proﬁtability Determinants in Banking Industry.

DOI: 10.5220/0009867201980204

In Proceedings of the International Conference on Creative Economics, Tourism and Information Management (ICCETIM 2019) - Creativity and Innovation Developments for Global

Competitiveness and Sustainability, pages 198-204

ISBN: 978-989-758-451-0

cial performance (Sholihah and Sriyana, 2013). Bank

Indonesia as the supervisor of banks in Indonesia pri-

oritizes the value of proﬁtability of a bank as mea-

sured by assets or what is known as ROA (return on

assets) which mostly come from public savings funds

(Kasmir, 2005). The greater the ROA of a bank shows

the success of management in generating proﬁts and

the bank can be included in the healthy category if it

has a minimum ROA ratio of 1.5% (No, ).

Based on the publication of Indonesian banking

statistics, there was a ﬂuctuation on the proﬁtability of

conventional and Islamic banks in the period of 2010-

2017 measured using Return On Assets (ROA). A sig-

niﬁcant decline occurred in Islamic banks in 2015,

which amounted to 2.29% and touched the value of

-1.38%. The conventional banks also experienced a

decline in 2016 but not as big as the Islamic banks. It

amounted to 0.79%. In 2016 the Islamic banks began

to rise again with an increase in ROA of 0.24% and

this number continued to increase until 2017.

The determinants of unstable proﬁtability in con-

ventional and Islamic banks are not easy to predict.

The different principles between these two types of

banks cannot determine whether they have similar de-

terminants. However, from the similarities of activ-

ities carried out, such as collecting and channeling

funds, it can be assumed that there are no different

determinants of proﬁtability between these two types

of banks (Zarrouk et al., 2016). In addition to in-

creasing proﬁtability, managing risk efﬁciently is also

important to maintain the bank stability. These two

important objectives of managing risk efﬁciently and

increasing proﬁtability will help management to man-

age risk and increase proﬁtability (Trabelsi and Trad,

2017). The study of credit risk management has at-

tracted the attention of many, investigating the factors

that encourage credit risk in the banking industry is

not only important for bank management but also for

the government (Misman et al., 2015). Taking into

consideration research gap, the study was conducted

in order to determine whether the quality of assets and

capital determine or inﬂuence the risk and proﬁtabil-

ity of the banking industry, both conventional and Is-

lamic banks.

2 LITERATURE REVIEW

Performance is how well a company can achieve the

economic goals, while the purpose of the economy is

to maximize economic welfare (Sukarno and Syaichu,

2006). Good bank performance is characterized by a

high level of proﬁtability (Kuncoro et al., 2002). The

most appropriate measure of banking performance is

to measure the ability of banks to generate proﬁts

from various activities they do, as in general the pur-

pose of a company is to achieve high values in which

it has to be able to efﬁciently and effectively manage

various types of activities (Syofyan, 2003). A bank

performance can be measured by analyzing the ﬁnan-

cial aspects, one of which is proﬁtability (Mardiyanto,

2009). Proﬁtability ratio is used to measure a bank’s

ability to generate proﬁts. Therefore, higher prof-

itability ratio is always associated with better perfor-

mance (Trabelsi and Trad, 2017).

2.1 The Effect of Asset Quality on

Credit / Financing Risk

The results of (Trad et al., 2017) research cannot ﬁnd

a signiﬁcant relationship between these two compo-

nents. However, (Fitrianto and Mawardi, 2006) stated

that the assessment of asset quality is conducted to see

the condition of bank assets to face the risk of loss by

maintaining the quality of its productive assets. The

same thing happens in the study of (Ariyanti, 2010)

who explained that productive assets means placing

the bank funds to reach the expected level of income

and allow risk. Therefore, observations and analy-

ses should be carried out to see how asset quality

affects the credit risk. So, asset quality inﬂuences

credit/ﬁnancing risk. Based on this explanation, the

following hypothesis can be developed:

Hypothesis 1: Asset quality inﬂuences

credit/ﬁnancing risk

2.2 The Effect of Capital on Credit /

Financing Risk

The stipulation of capital is intended so that banks

have sufﬁcient capital to reduce the possibility of risk

arising as a result of the development of asset expan-

sion, especially the assets that are categorized as prof-

itable and at the same time risky (Pamungkas, 2016).

Capital refers to the amount of available funds owned

by a bank to support its business and it is expected

to be a safeguard if there is a loss (Athanasoglou

et al., 2008). Adequate amount of capital becomes

a safeguard to deal with unexpected losses and inci-

dent (Trad et al., 2017). Research on capital aspects

shows whether it will be able to absorb bank losses as

a result of investing funds or decreasing assets in the

future (Muljono, 1986). Bank capital is the main in-

dicator in reducing credit risk in Islamic banks (Trad

et al., 2017). The research conducted by (Trabelsi

and Trad, 2017) states that capital is negatively and

signiﬁcantly correlated with credit risk because ade-

quate amount of capital will provide better protection

Assets Quality and Capital as Risk and Proﬁtability Determinants in Banking Industry

199

against the banking crisis. Based on this explanation,

the following hypothesis can be developed:

Hypothesis 2: Capital has a negative effect on

credit/ﬁnancing risk

2.3 The Effect of Asset Quality on

Proﬁtability

Asset quality is a comparison between classiﬁed as-

sets (substandard credit, doubtful credit, bad credit)

and the total credit provided (Siahaan and Asandim-

itra, 2018). The assessment of asset quality can re-

ﬂect the ability of bank management in managing its

productive assets. The placement of bank fund in

the form of productive assets aims to achieve the ex-

pected level of income (Ariyanti, 2010). However, in

a bank research in Malaysia, asset quality has a nega-

tive effect on proﬁtability (Wasiuzzaman and Tarmizi,

2010) (Mun and Thaker, 2016). It also occurs in 94

Islamic banks operating in 18 countries (Trabelsi and

Trad, 2017). Asset quality negatively affects the prof-

itability of banks in Indonesia (Siahaan and Asandim-

itra, 2018). However, different things happen to 51

banks operating in MENA where proﬁtability is pos-

itively affected by the asset quality (Zarrouk et al.,

2016). Based on this explanation, the following hy-

pothesis can be developed:

Hypothesis 3: Asset quality has a negative effect

on proﬁtability.

2.4 The Effect of Capital on

Proﬁtability

Adequate amount of capital becomes the safeguard

and guarantees bank proﬁtability and stability (Trad

et al., 2017). Capital refers to the amount of avail-

able funds owned by a bank to support the its busi-

ness (Athanasoglou et al., 2008). The higher the bank

capital, the lower the need for external funding and

therefore it will increase proﬁtability (Wasiuzzaman

and Tarmizi, 2010). On the other hand, low capital

of a bank causes a decrease in public trust which in

turn can reduce proﬁtability (Sukarno and Syaichu,

2006). Bank capital has a positive and signiﬁcant in-

ﬂuence on the proﬁtability of domestic banks in the

UK (Kosmidou et al., 2005), 96 Islamic banks oper-

ating in 18 countries (Trad et al., 2017), and Islamic

as well as conventional banks in Malaysia (Mun and

Thaker, 2016). The same thing happens in the study

of (Zarrouk et al., 2016) which shows that proﬁtabil-

ity is positively inﬂuenced by the bank’s capital level,

because the higher the capital, the lower the external

funding needed and therefore the higher the proﬁtabil-

ity. However, different thing happens to Islamic banks

in Malaysia, where capital has a negative inﬂuence on

bank proﬁtability (Wasiuzzaman and Tarmizi, 2010).

Based on this explanation, the following hypothesis

can be developed:

Hypothesis 4: Capital has a positive effect on

proﬁtability.

2.5 The Effect of Credit / Financing

Risk on Proﬁtability

Credit risk arises from the inability of the borrow-

ers to fulﬁll the obligation (Fayed, 2013). Problem-

atic ﬁnancing results in the loss of the opportunity

to earn income from the ﬁnancing provided so that

it affects earnings and adversely affects ROA (Pa-

mungkas, 2016). Credit risk has a negative impact on

the proﬁtability of Islamic banks in Indonesia (Dodi

et al., ) and 78 Islamic banks in 12 MENA coun-

tries and Pakistan (Trad et al., 2017). Research by

(Ali et al., 2011) states that credit risk also has a

negative inﬂuence on proﬁtability as measured by re-

turns on assets and returns on equity. The higher the

credit risk, the higher the bank’s capacity to absorb

loan losses (Fayed, 2013).It will give impact on bank

productivity and negatively effect bank proﬁtability.

Based on this explanation, the following hypothesis

can be developed:

Hypothesis 5: Credit/ﬁnancing risk has a negative

effect on proﬁtability.

3 RESEARCH METHOD

Figure 1: Operationalization of Research Variables.

The population in this study was 115 banks in In-

donesia, consisting of 103 conventional banks and

12 Islamic banks. This study used purposive sam-

pling technique with the following criteria: (1) banks

that regularly publish complete annual ﬁnancial state-

mentsas of December 31, 2010 until December 31,

2017; and (2) conventional banks listed on the In-

donesia Stock Exchange (IDX) no later than Decem-

ber 31, 2010 and recorded until December 31, 2017.

ICCETIM 2019 - International Conference on Creative Economics, Tourism Information Management

200

Based on these criteria, a sample of 39 banking in-

dustries was obtained consisting of 29 conventional

banks and 10 Islamic banks. Thus, the total observa-

tion of all research samples were 312 observations ob-

tained from 39 banks multiplied by 8 years of obser-

vation. The explanation of the variables is explained

in Figure 1 Operationalization of Research Variables.

This research used regression equation model in han-

dling panel data, namely Pooled Regression Model

(Command Effect). This model assumes that the in-

tercept and regression coefﬁcient (slope) are constant

for all companies over the period of time (years) an-

alyzed. The data were analyzed using path analysis.

This study used random procurement method, namely

the PLS SEM method. Therefore, the assumption of

normality will not be a problem and PLS does not re-

quire a minimum number of samples. PLS is a multi-

variate statistical technique that can handle many in-

dependent variables, even if multicollinearity occurs

between these variables. The program used as a tool

is the WarpPLS 6.0 program.

4 RESULT

A structure model is said to be ﬁt if supported by em-

pirical data. Goodness of ﬁt test results using Warp-

PLS 6.0 based on WarpPLS User Manual: Version 6.0

obtained the following data in Figure 2.

Figure 2 shows that almost all indicators mea-

suring the adequacy of models in both conventional

and Islamic banks state that the model is ﬁt. There

are only four indicators of model adequacy stating

that the model is not ﬁt in conventional banks, which

are Average VIF block, Average full collinearity VIF,

Sympson’s paradox ratio, and R-squared contribution

ratio. Whereas, in Islamic banks there are only three

indicators of model adequacy which state the same,

which are Average block VIF, Average full collinear-

ity VIF and Nonlinear bivariate causality direction ra-

tio. Thus, it can be concluded that the model formed

matches the empirical data and can be used for further

discussion.

Figure 2: Analysis of the Goodness of Fit Model.

4.1 Hypothesis Testing

Complete results of hypotheses testing can be seen

below.

Figure 3: Path Analysis Results.

Based on Figure 3, the results of hypothesis test-

ing can be explained as follows:

1. Hypothesis 1

The test result on the effect of asset quality on

credit risk in conventional banks shows a coefﬁ-

cient of 0.98 and signiﬁcance of < 0.01. Whereas

in Islamic banks, the test result shows a coefﬁ-

cient of 0.99 and signiﬁcance of < 0.01. It means

that H1 is accepted; asset quality has a positive

and signiﬁcant effect on credit risk in both con-

ventional and Islamic banks.

2. Hypothesis 2

The test result of the effect of capital on credit risk

in conventional banks shows a coefﬁcient of 0.02

and a signiﬁcance of 0.37. Whereas in Islamic

banks, the test result shows a coefﬁcient of -0.00

and a signiﬁcance of 0.50. So, it means H2 is re-

jected; the capital has no impact on credit risk in

both conventional and Islamic banks.

3. Hypothesis 3

The test result of the effect of asset quality on

proﬁtability in conventional banks shows a co-

efﬁcient of 0.49 and a signiﬁcance of < 0.01.

Whereas in Islamic banks, the test result shows

a coefﬁcient of -0.58 and a signiﬁcance of < 0.01.

It means that H3 is rejected in conventional banks

and H3 is accapted in Islamic banks. Asset quality

has a positive and signiﬁcant effect on the prof-

itability of conventional banks while in Islamic

banks it has a negative and signiﬁcant effect.

4. Hypothesis 4

The test result of the effect of capital on proﬁtabil-

ity in conventional banks shows a coefﬁcient of

0.19 and a signiﬁcance of < 0.01. Whereas in Is-

lamic banks, the result shows a coefﬁcient of 0.13

and a signiﬁcance of 0.11. Capital has a positive

and signiﬁcant effect on the proﬁtability of con-

ventional banks. It means that H4 is accapted in

conventional banks and H4 is rejected in Islamic

banks.

5. Hypothesis 5

The test result of the effect of credit risk on prof-

itability in conventional banks shows a coefﬁcient

Assets Quality and Capital as Risk and Proﬁtability Determinants in Banking Industry

201

of -1.14 with a signiﬁcance of < 0.01. As for Is-

lamic banks, the result shows a coefﬁcient of -0.30

with a signiﬁcance of < 0.01. It means that H5

is accepted; credit risk has a negative effect on

the proﬁtability of both conventional and Islamic

banks.

4.2 Discussion

The test result on the effect of asset quality on credit

risk in conventional banks shows a coefﬁcient of 0.98

and signiﬁcance of < 0.01. Whereas in Islamic banks,

the test result shows a coefﬁcient of 0.99 and signiﬁ-

cance of < 0.01. It means that H1 is accepted; asset

quality has a positive and signiﬁcant effect on credit

risk in both conventional and Islamic banks. The re-

sults of this study are not in accordance with (Trad

et al., 2017) but in line with the theory put forward

by (Fitrianto and Mawardi, 2006) who stated that the

assessment of asset quality is conducted to see the

condition of bank assets to face the risk of loss by

maintaining the quality of its productive assets. Ac-

cordingly with (Ariyanti, 2010) who stated that most

of the fund placements in productive assets are in the

form of loans which may cause risk. The higher the

placement of funds in productive assets, the bigger

chance to increase credit risk. Therefore, it is still im-

portant for banks to maintain asset quality in order to

reduce credit risk.

The test result of the effect of capital on credit risk

in conventional banks shows a coefﬁcient of 0.02 and

a signiﬁcance of 0.37. Whereas in Islamic banks, the

test result shows a coefﬁcient of -0.00 and a signiﬁ-

cance of 0.50. So, it means H2 is rejected; the capital

has no impact on credit risk in both conventional and

Islamic banks. The results of this study indicate that

conventional and Islamic banks capital are not used

for risk-bearing loans. It is conﬁrmed by (Ismail et al.,

2018) who states that capital is used to support assets

that contain or cause risks such as ﬁnancing. Thus,

banks have the freedom to use capital because it will

not affect their credit risk.

The test result of the effect of asset quality on

proﬁtability in conventional banks shows a coefﬁcient

of 0.49 and a signiﬁcance of < 0.01. Whereas in

Islamic banks, the test result shows a coefﬁcient of

-0.58 and a signiﬁcance of < 0.01. Asset quality

has a positive and signiﬁcant effect on the proﬁtabil-

ity of conventional banks while in Islamic banks it

has a negative and signiﬁcant effect. It shows that

conventional banks are far better at managing asset

quality. This result is in accordance with (Zarrouk

et al., 2016). Meanwhile, Islamic banks must focus

more on credit risk, because if the improvement on

asset qualityis not accompanied with good manage-

ment on credit risk, it will increase costs and reduce

bank proﬁtability (Wasiuzzaman and Tarmizi, 2010).

The results are in accordance with (Wasiuzzaman and

Tarmizi, 2010), (Mun and Thaker, 2016), (Siahaan

and Asandimitra, 2018).

The test result of the effect of capital on proﬁtabil-

ity in conventional banks shows a coefﬁcient of 0.19

and a signiﬁcance of ¡0.01. Whereas in Islamic banks,

the result shows a coefﬁcient of 0.13 and a signiﬁ-

cance of 0.11. Capital has a positive and signiﬁcant

effect on the proﬁtability of conventional banks. It is

in accordance with (Trad et al., 2017) (Akhtar et al.,

2011), (Zarrouk et al., 2016). Meanwhile in Islamic

banks, capital does not have a signiﬁcant effect on

proﬁtability and it is in accordance with (Akhtar et al.,

2011). Capital condition in Islamic banks during the

eight years of observation was very good, which av-

eraged 25.19%. This condition reﬂects that Islamic

banks rely more on ﬁnancing as a source of income

and do not use the potential of capital to increase prof-

itability (Hutagalung et al., 2013). This statement is

reinforced by (Sangmi and Nazir, 2010) in their re-

search in banks in India which shows that high capital

indicates that the bank is conservative and does not

use all potential capital. It also shows that Islamic

banks are lack of product development by using ex-

isting capital to obtain proﬁtability.

The test result of the effect of credit risk on prof-

itability in conventional banks shows a coefﬁcient of

-1.14 with a signiﬁcance of < 0.01. As for Islamic

banks, the result shows a coefﬁcient of -0.30 with a

signiﬁcance of < 0.01. It means that H5 is accepted;

credit risk has a negative effect on the proﬁtability of

both conventional and Islamic banks. The results of

this study are in accordance with(Dodi et al., ), (Ali

et al., 2011) (Trad et al., 2017). The higher the credit

risk, the higher the bank’s capacity to absorb loan

losses (Fayed, 2013). It will give impact on bank pro-

ductivity and will have a negative effect on bank prof-

itability. Then the bank must maintain a high level of

credit risk so as to reduce proﬁts.

The magnitude of the effect of asset quality and

capital on credit risk is 98%, while the magnitude of

the inﬂuence of asset quality, capital, and credit risk

on proﬁtability is 40%. The magnitude of the effect of

asset quality and capital on credit risk is 98%, while

the magnitude of the inﬂuence of asset quality, capi-

tal, and credit risk on proﬁtability is 82%. The impli-

cation of this research is the understanding that man-

aging asset quality well is very important because it

will affect credit risk. High asset quality will affect

proﬁtability, but the it must be managed properly so as

not to cause losses. Increased asset quality is poorly

ICCETIM 2019 - International Conference on Creative Economics, Tourism Information Management

202

managed in Islamic banks, so it leads to a decrease

in proﬁtability. Likewise with credit risk that must be

maintained so that it is not too high so as to reduce

proﬁts..

5 CONCLUSION AND

LIMITATION

The main objective of this research is to ﬁnd out the

impact of asset quality and capital as determinants

of credit risk and proﬁtability in the banking indus-

try. Overall the results of this study indicate that asset

quality has a positive and signiﬁcant effect on the risk

of credit or ﬁnancing in both conventional and Islamic

banks. Meanwhile, capital does not have an inﬂuence

on credit or ﬁnancing risk in both conventional and

Islamic banks. Asset quality has a positive and signif-

icant effect on the proﬁtability of conventional banks.

However, in Islamic banks, it has a negative and sig-

niﬁcant effect. Capital has a positive and signiﬁcant

impact on the proﬁtability of conventional banks but

has no inﬂuence on Islamic banks. Credit risk has a

negative and signiﬁcant impact on proﬁtability in both

conventional and Islamic banks. It is important for

the management of both types of banks to ﬁnd out the

factors that inﬂuence credit or ﬁnancing risk and prof-

itability in the banking industry. This research is only

limited to the banking industry listed on the Indone-

sia Stock Exchange in 2010 until 2017. It does not

involve external factors that might have inﬂuence risk

and proﬁtability. The risks used is credit risk which is

the biggest risk of the banking industry.

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