Zoya Khan, PhD Scholar, Bahria University, Islamabad, Pakistan. The Third Islamic Finance Conference Determinants of capital structure of Islamic and conventional commercial banks: Evidence from Pakistan Zoya Khan, PhD Scholar, Bahria University, Islamabad, Pakistan. Dr. Muhammad Yar Khan, Assisant Professor, COMSATS Institute of Information Technology, Wah Campus, Pakistan. Ehsan Karim, COMSATS Institute of Information Technology, Wah Campus, Pakistan. 1

Introduction The Third Islamic Finance Conference The ideal mix of debt and equity for a firm is the one that maximizes the value of the firm and minimizes the overall cost of capital. The debt irrelevance proposition of Modigliani and Miller (1958) in perfect capital markets. However, if corporate taxes exist then capital structure matters a great deal because of the fact that interest is a tax deductible expense and generates a valuable tax shield (Modigliani and Miller, 1963). 3

Introduction The Third Islamic Finance Conference But considering risk and consequent costs of higher debt, the trade-off theory states that firms can determine an optimal capital structure by weighing the costs and benefits of an additional dollar of debt. The costs of debt include potential bankruptcy costs and agency conflicts between shareholders and debt holders (Fama and French, 2002). Alternatively, pecking order theory says that firm will borrow, rather than issuing equity when internal funds are insufficient to finance the capital expenditure program (Myers and Majluf, 1984). In sum, different conditional theories of capital structure suggest different debt levels due to the fact that each theory is based on different assumptions.

Introduction The Third Islamic Finance Conference Studies have excluded the financial firms from their analysis due to the reasons that their decisions are by-product of various regulations. Bank assets and functions are not the same as those of non-financial firms. Little empirical research on the factors that affect the capital structure. Comparison of commercial and Islamic Banks. Mixed findings of earlier empirical studies. 3

The Third Islamic Finance Conference Introduction Since 1947 conventional commercial banks got a dominant position in the economy of Pakistan due to limited and underdeveloped equity market. The process of Islamization of banking and financial system of Pakistan was started in 1977. In early 1980s several measures were taken to introduce the interest-free banking in Pakistan and as a parallel and compatible system in line with the best international practices. Consequently, Islamic Banking Department (IBD) was established at State Bank of Pakistan on 15th September 2003. 4

The Third Islamic Finance Conference Objectives 1. How Islamic and conventional commercial banks choose their capital structure? 2. What are the most significant bank-specific factors that affect the capital structure of Islamic and conventional commercial banks? 2

LITERATURE REVIEW The Third Islamic Finance Conference Gropp and Heider (2010) analyzed the data of 200 largest public ally traded banks in the United States and 15 European countries during 1991-2004 to investigate the factors that affect the capital structure. Amidu (2007) analyzed the data of 19 banks in Ghana during 1998-2003 to investigate the factors that affect the capital structure. Results indicate that profitability, bank size, asset structure, growth and corporate taxes are some important factors that affect the capital structure of banks. PROFILTABILITY: Qureshi (2009), Sheikh and Wang (2011), Sheikh and Qureshi (2014) SIZE Titman and Wessels (1988), Booth et al. (2001), GROWTH Deesomsak et al. (2004) TANGIBILITY Berger and Udell (1994), Nivorozhkin (2004) EARNING VOLTALITY Booth et al. (2001), Fama and French (2002), de Jong et al. (2008). Shibru et al. (2015)

Data The Third Islamic Finance Conference To estimate the relationship between book leverage and bank-specific variables, data was taken from annual reports published by the banks listed on Karachi Stock Exchange (KSE) Pakistan during 2004-2014. The data of 20 conventional and 5 Islamic commercial banks was found complete for the period under study. Consequently, we obtained an unbalanced panel data due to the fact that different conventional and Islamic commercial banks listed on KSE at different point in time during the study period. Moreover, one year data is lost due to taking change in total assets to determine the level of growth, and change in profit before taxes to measure the variations in earnings. Consequently, final sample consist of 177 bank-year observations of conventional commercial banks and 39 bank-year observations of Islamic commercial banks over a period of ten years. 5

VARIABLES The Third Islamic Finance Conference Table 1: Variables’ Definition Variable Abbreviation Definition Book leverage BLev Total Liabilities divided by Total Assets Profitability Profit Profit after tax divided by Total assets Bank size BSIZE Natural log of total assets Tangibility Tang Fixed operation assets divided by Total assets Growth   Earnings volatility EV Profit before tax-Profit before tax t-1 divided by profit after tax 6

Descriptive Statistics (Islamic) The Third Islamic Finance Conference Table II: Descriptive statistics (Islamic banks) Variable Observation Mean Standard deviation Minimum Maximum BLEV it 41 0.9664 0.1420 0.6023 0.8425 PROFit -0.0008 0.0133 -0.0411 0.0177 SIZE it 18.711 0.911 16.218 19.316 GROW it 0.4904 0.6627 -0.9806 3.6699 TANG it 0.0495 0.0355 0.0190 0.2196 EVOL it -0.9257 9.5933 53.255 16.339 8

Descriptive Statistics (commercial) The Third Islamic Finance Conference Table III: Descriptive statistics (commercial banks) Variable Observation Mean Standard deviation Minimum Maximum BLEV it 176 0.931 0.0544 0.678 0.984 PROF it 0.004 0.032 0.078 0.039 SIZE it 19.155 1.1044 15.92 21.392 GROW it 0.3000 0.2584 0.2277 2.9000 TANG it 0.0394 0.0267 0.0034 0.2245 EVOL it -0.4133 4.394 33.544 14.580 8

Pair-wise correlation of Islamic banks The Third Islamic Finance Conference Table VI: Pair-wise correlation of Islamic banks Variable BLEV it PROFit SIZE it GROW it TANG it EVOL it 1.000   0.300 ⃰ ⃰ ⃰ 0.876 ⃰ ⃰ ⃰ 0.635 ⃰ ⃰ ⃰ 0.045 -0.117 -0.043 -0.661 ⃰ ⃰ ⃰ -0.484 ⃰ ⃰ ⃰ -0.677 ⃰ ⃰ ⃰ -0.086 0.029 0.415 ⃰ -0.006 0.228 ⃰ ⃰ ⃰ -0.114 10

Pair-wise correlation of Commercial banks The Third Islamic Finance Conference Table VII: Pair-wise correlation of commercial banks Variable BLEV it PROFit SIZE it GROW it TANG it EVOL it 1.000   0.067 0.307 ⃰ ⃰ ⃰ 0.496 ⃰ ⃰ ⃰ -0.178 ⃰ ⃰ -0.007 -0.144 ⃰ ⃰ ⃰ -0.325 ⃰ ⃰ ⃰ -0.454 ⃰ ⃰ ⃰ -0.473 ⃰ ⃰ ⃰ -0.061 0.212 0.080 0.100 0.397 ⃰ ⃰ ⃰ -0.096 10

Pair-wise correlation of Commercial banks The Third Islamic Finance Conference Table VII: Pair-wise correlation of commercial banks Variable BLEV it PROFit SIZE it GROW it TANG it EVOL it 1.000   0.067 0.307 ⃰ ⃰ ⃰ 0.496 ⃰ ⃰ ⃰ -0.178 ⃰ ⃰ -0.007 -0.144 ⃰ ⃰ ⃰ -0.325 ⃰ ⃰ ⃰ -0.454 ⃰ ⃰ ⃰ -0.473 ⃰ ⃰ ⃰ -0.061 0.212 0.080 0.100 0.397 ⃰ ⃰ ⃰ -0.096 10

The Third Islamic Finance Conference Regression (Islamic Banks) Variable: Dependent Variable: BLEV it OLS FE RE   Co-efficient t-statistics C -0.9520*** -4.62 -0.1441 -0.50 -0.9620*** -4.61 PROFit -2.1512 -1.50 -2.5578** -2.76 -1.5502 -1.37 SIZE it 0.0880*** 6.62 0.0719*** 5.54 0.0990*** GROW it 0.0147 0.84 0.0096 0.82 0.0139 0.95 TANG it -0.6155 -1.53 -2.3955*** -4.48 -0.6345 EVOL it 0.0005 0.51 -0.0004 -0.59 0.0002 N 41 R2 0.6195 0.5886 0.618 F-statistics 27.990 34.971 27.17 Prob (F) 0.000

The Third Islamic Finance Conference Regression (conventional Banks) Table IX: Effects of Independent variables on dependent variable of commercial banks Variable: Dependent Variable: BLEV it OLS FE RE   Co-efficient t-statistics C 0.7070*** 7.52 0.9458*** 7.95 0.7235*** 8.33 PROFit -0.4321** -3.26 -0.659*** -4.63 -0.5449*** -3.75 SIZE it 0.0177*** 3.67 0.0044 0.95 0.0065 2.44 GROW it -0.0235 -2.47 -0.0255*** -3.22 -0.0334*** -3.99 TANG it -0.5662* -2.91 -0.8753*** -3.77 -0.7626*** -3.74 EVOL it 0.0006 0.33 0.0009* 2.77 0.0006* 2.71 N 176 R2 0.5459 0.5182 0.5434 F-statistics 16.8400 18.7700 16 Prob (F-stat) 0.0001 0.0000

The Third Islamic Finance Conference Conclusion Results suggest that conventional commercial banks are more levered than Islamic commercial banks. Regression results indicate that profitability is negatively related to book leverage. The negative relationship confirms the prophecy of pecking order theory. Bank size is positively related to book leverage. The positive relationship confirms the predictions of trade-off theory. Growth is negatively related to book leverage of conventional banks. The negative relationship is congruent with the predictions of pecking order theory and agency explanations. 12

The Third Islamic Finance Conference Conclusion Tangibility is negatively while earnings volatility is positively related to book leverage. Both of the relationships are incongruent with the predictions of trade-off theory. Only three variables namely profitability, size and tangibility have material effects on capital structure choice of Islamic commercial banks. Alternatively, profitability, size, growth tangibility and earnings volatility are important factors that determine the capital structure choice of conventional commercial banks in Pakistan. The notable finding of this study is that all commercial banks are highly leveraged than non-financial firms in Pakistan. 12

The Third Islamic Finance Conference Thank You