THE INFLUENCE OF FINANCING VARIABLES AND SOCIAL VARIABLE ON THE PERFORMANCE OF ISLAMIC BANKS IN INDONESIA

THE INFLUENCE OF FINANCING VARIABLES AND SOCIAL VARIABLE ON THE PERFORMANCE OF ISLAMIC BANKS IN

INDONESIA

PENGARUH VARIABEL PEMBIAYAAN DAN VARIABEL SOSIAL TERHADAP KINERJA BANK ISLAM

DI INDONESIA

Written by: Ali Ridho 20130430323

FACULTY OF ECONOMICS AND BUSINESS UNIVERSITAS MUHAMMADIYAH YOGYAKARTA

THE INFLUENCE OF FINANCING VARIABLES AND SOCIAL VARIABLE ON THE PERFORMANCE OF ISLAMIC BANKS IN

INDONESIA

PENGARUH VARIABEL PEMBIAYAAN DAN VARIABEL SOSIAL TERHADAP KINERJA BANK ISLAM

DI INDONESIA

Undergraduate Thesis

In partial fulfillment for the requirement for the degree of Bachelor of Economics (Sarjana Ekonomi) at the International Program for Islamic Economics and

Finance (IPIEF) the Department of Economics and Business

Written by: Ali Ridho 20130430323

FACULTY OF ECONOMICS AND BUSINESS UNIVERSITAS MUHAMMADIYAH YOGYAKARTA

ii

DECLARATION

Name : Ali Ridho

Student Number : 20130430323

I hereby declare that this undergraduate thesis entitled “The Influence of Financing Variables and Social Variables on the Performance of Islamic Bank in Indonesia” does not consist of any content that ever being proposed for any degree in other university, and ideas of any research and publication of others, in exception all quotes and ideas which are purposely taken are considered as the research references, and listed in the reference list. Therefore, if any violation of intellectual rights is found in this study, I agree to accept any relevant academic consequences.

Yogyakarta, 28 February 2017 Ali Ridho

iii MOTTO

“When everything goes smoothly, just remember that life always got surprise”- Ali Ridho

iv PREFACE Bismillahirrahmanirrahim

Assalamu’alaikum wa rahmatullahi wa barakatuh

Alhamdulillah, praise be to Allah Subhanahu wa Ta’ala for blessing the writer with health and joy for finally finishing this undergraduate thesis Salawat and Salam to Rasulullah Shallallahu Alaihi wa Salam, hopefully His shafa’at will be abundant in days later.

This undergraduate thesis entitled “The Influence of Financing Variables and Social Variable on the Performance of Islamic Bank in Indonesia” is submitted as partial fulfillment to achieve bachelor degree of economics, focusing on Islamic economics and finance. The process of writing this undergraduate thesis has involved directly and indirectly many people and parties that the author would like to express gratitude to all people and parties below:

1. My family, especially for my parents and all of my brothers who have educated me and give motivation, pray for me and love me.

2. Bapak Ayif Fathurrahman, SE., M.Ec. as my undergraduate thesis advisor who has provided guidance and suggestions to author since the beginning of the study until the completion of this thesis writing..

3. Almarhum Bapak Masyhudi Muqorobin, M.Ec., Ph.D., Akt. as my co-supervisor and Head of International Program for Islamic Economics and Finance who has provided input and suggestions to complete the preparation of this thesis.

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4. The entire Lecturer and Staff in International Program for Islamic Economics and Finance for all of knowledge given to the author in which these knowledge really help the author in doing the research. Hopefully these knowledge may be beneficial for human being.

5. My friends in college, especially entire friend in IPIEF. Thank you for the togetherness we have been through.

In addition to people above, there are other people and parties, which gave much supports and helps during the making of this minor thesis, but the author could not mention one by one. However, the author, by this chance would like to say thank you and send best regards to all unstated parties for the hopes that God will bless all the mentioned and unmentioned parties of their kindness.

Finally, the author believes that this undergraduate thesis is not perfect yet, hence, the constructive corrections from outer parties are hoped and expected to enrich and lead this minor thesis into a better one. Hopefully, this undergraduate thesis would be useful in enriching the knowledge of all reader.

Amin

Wassalamu’alaikum

Yogyakarta, 28 February 2017

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TABLE OF CONTENTS

DECLARATION ... ii

MOTTO ... iii

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TABLE OF CONTENTS ... vi

LIST OF THE TABLES ... viii

LIST OF THE FIGURES ... ix CHAPTER I ... Error! Bookmark not defined. INTRODUCTION ... Error! Bookmark not defined. 1.1 Research Background ... Error! Bookmark not defined. 1.2 Research Question ... Error! Bookmark not defined. 1.3 Research Objectives ... Error! Bookmark not defined. 1.4 Research Benefits ... Error! Bookmark not defined. 1.5 Research Plan ... Error! Bookmark not defined. CHAPTER II ... Error! Bookmark not defined. THEORITICAL FRAMEWORK AND HYPOTHESISError! Bookmark not defined.

2.1 Theories ... Error! Bookmark not defined. 2.1.1 Islamic Economics System ... Error! Bookmark not defined. 2.1.2 Islamic Bank ... Error! Bookmark not defined. 2.1.3 Islamic Contracts ... Error! Bookmark not defined. 2.1.3.1 Mudharabah ... Error! Bookmark not defined. 2.1.3.2 Murabahah ... Error! Bookmark not defined. 2.1.3.3 Musharakah ... Error! Bookmark not defined. 2.1.3.4 Ijara ... Error! Bookmark not defined. 2.1.3.5 Istisna ... Error! Bookmark not defined. 2.1.3.6 Qard Al-hassan ... Error! Bookmark not defined. 2.1.4 Financial Intermediaries ... Error! Bookmark not defined. 2.1.5 Financial Risk ... Error! Bookmark not defined. 2.1.6 Financial Performance... Error! Bookmark not defined. 2.1.7 Profitability ... Error! Bookmark not defined.

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2.1.7.1 Return on Assets (ROA) ... Error! Bookmark not defined. 2.2 Previous Study ... Error! Bookmark not defined. 2.3 Hypothesis ... Error! Bookmark not defined. 2.4 Research Framework... Error! Bookmark not defined. CHAPTER III ... Error! Bookmark not defined. DATA AND METODOLOGY ... Error! Bookmark not defined. 3.1 Research Variable and Data Type... Error! Bookmark not defined. 3.2 Data Colleting Method and Sources ... Error! Bookmark not defined. 3.3 Operational Definitions ... Error! Bookmark not defined. 3.4 Research Model & Analysis Method .... Error! Bookmark not defined. 3.4.1 Linear Regression Method ... Error! Bookmark not defined. 3.4.2 Classical Assumption Test ... Error! Bookmark not defined. 3.4.2.1 Autocorrelation Test ... Error! Bookmark not defined. 3.4.2.2 Heteroscedasticity Test ... Error! Bookmark not defined. 3.4.3 Regression Analysis ... Error! Bookmark not defined. 3.4.2.1 Coefficient of Determination (R-Squared)Error! Bookmark not defined.

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5.1 Conclusion ... Error! Bookmark not defined. 5.2 Suggestion ... Error! Bookmark not defined.

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Reference ... Error! Bookmark not defined. Appendixes ... Error! Bookmark not defined.

LIST OF THE TABLES

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Table 4. 1 Descriptive

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Table 4. 10 Total Operating Income from Income Statement ... Error! Bookmark not defined.

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LIST OF THE FIGURES

Figure 1.1 ROA of Islamic Bank in Indonesia ... Error! Bookmark not defined. Figure 2.1 Research Framework ... Error! Bookmark not defined.

ABSTRAK

Tujuan dari penilitan ini adalah untuk menganalisis pengaruh variabel pembiayaan dan variabel sosial dari bank islam di Indonesia terhadap kinerja bank islam di Indonesia, dengan menggunakan data bulanan dari tahun 2011-2013 dengan menggunakan model regresi berganda. Hasil penelitian menunjukkan bahwa dari 6 independent variabel, hanya 3 yang mempunyari pengaruh signifikan terhadap keuntungan, yaitu murabahah dan musharakah dan qard al-hassan. Murabahah mempunyai hubungan positif terhadap kinerja bank, sedangkan musharakah dan qard al-hassan mempunyai hubungan negatif terhadap kinerja bank. Variabel mudharabah, ijarah, dan istisna tidak mempunyai pengaruh signifikan terhadap kinerja bank Islam di Indonesia.

ABSTRACT

The purpose of this research is to analyze the influence of financing and social variable on the performance of Islamic bank in Indonesia. This research will use secondary monthly data from 2011 to 2013, and analyze using multiple regression model. The research findings was indicate, through 6 independent variables used, there were only 3 variables that significantly influence to performance of Islamic bank. They are murabahah, musharakah and qard al-hassan. Murabahah got positive relationship to performance of Islamic bank, while musharakah and qard al-hassan got negative relationship with performance of Islamic bank. The variables of mudharabah, ijarah, and istisna were not significantly influence to the performance of Islamic bank.

Keywords: Islamic Bank Performance, ROA, Financing Variables, Social Variable.

CHAPTER I INTRODUCTION 1.1 Research Background

Nowadays, Islamic economics system become the world’s concern as new solution for many economics problem that exists, since Islamic economics system is focusing more on economics welfare and the well-known interest-free system which support people. Islamic economics is rapidly developed at the current time because there are so many scholars that doing research in this subject and also many researchers that looking for a new solution for the problem that exists in this era.

Inside the Islamic economics system, there is Islamic bank as a place to apply the system itself. In Islamic bank, people can see and try how the Islamic economics system works in banking. There are many kind of contracts in Islamic bank, i.e trade contract, leasing contract, loan contract, investment contract, and others. With many kind of contracts in each category, people can find what they needs. In this study, the contracts are categorize into two categories, the financial contracts and social contracts.

Islamic banking using faith approach based as banking basic’s system; means it is influenced by the Islam faith, contradically with conventional banking. According to the Institute of Islamic Banking & Insurance (which was founded in 1990), Islamic banking refers to a system of banking or banking activities consistently to the principles of the Sharia’h (Islamic rulings) and its practical application through the development of Islamic Economics.

According to Al Baraka Banking Group (a licensed wholesale bank by the Central Bank of Bahrain founded in 1984), an Islamic bank is an institution that mobilizes financial resources and invests them in an attempt to achieve predetermined Islamically-acceptable social and financial objectives. Both mobilization and investment of funds should be conducted in accordance with the principles of the Islamic Sharia’h.

There are several principles associated with Islamic finance. First principle states no investment is made in contradiction to the Sharia’h rules. Thus, all investments must be made in line with Sharia’h. Second principle refers to the prohibitions under Sharia’h. The investments made under Islamic finance must not deal to undesirable and prohibited under Sharia’h which include but are not limited to riba (which is taking or receiving interest), maysir (which include speculation or gambling), gharar (which is the uncertainty regarding the subject matter or terms of a contract-this prohibition extends to trading the things one does not own), and investments involving alcohol, drugs and money laundering activities. Third principle is on risk sharing. Risk relating to any transaction must be shared between at least two parties. This ensures the parties invest funds and manage the funds share to the business risk in return for a share in profit (GTG, 2012).

Islamic finance does not recognize money as a commodity but rather as a means to carry out a transaction. The financing facilities offered by Islamic banking are in the form of contracts. These contracts are entered into by the bank and the recipient of funds. These contracts do not involve the charging of

interest but rather profit/loss sharing contracts. The most commonly used financing contracts are; murabahah, musharakah, mudharabah, istisna, ijara and qard al-hassan. Once the contract is approved, the bank will purchase the asset and the borrower will be given a period of time to pay the bank for the asset at a price which include the asset price plus a markup profit for the bank. This mark up is determined before the asset is bought and the borrower is made aware. The assets could be used as collateral for the transaction or the borrower provide another form of collateral. The borrower can pay in predetermined installments the whole amount owed (cost plus mark up).

According to Antonio (2001), mudharabah is a partnership contract between two parties where the first party (shahibul maal) provides the entire capital, while the other party (mudharib) become a manager, where the business profits split in percentage (ratio) as agreed, whereas if the loss is borne by the owners of capital as long as the losses not due to the negligence of the manager, if the loss was caused by negligence of the manager then the manager should be responsible for the losses. In fiqh muamalah, mudharabah as qiradh, which means form of cooperation between owners of capital (shohibul mal / rabbul mall) and business managers (mudharib) to conduct business where the profits of the business are split between two parties, as the agreement in the beginning.

Mudharabah is taken from the Arabic language that is dharb, Adharbu fil ardhi which means that is traveling to trade, as Allah says in Surah Al Mujammil verse 20:

“Indeed, your Lord knows, [O Muhammad], that you stand [in prayer] almost two thirds of the night or half of it or a third of it, and [so do] a group of those with you. And Allah determines [the extent of] the night and the day. He has known that you [Muslims] will not be able to do it and has turned to you in forgiveness, so recite what is easy [for you] of the Qur'an. He has known that there will be among you those who are ill and others traveling throughout the land seeking [something] of the bounty of Allah and others fighting for the cause of Allah. So recite what is easy from it and establish prayer and give zakah and loan Allah a goodly loan. And whatever good you put forward for yourselves - you will find it with Allah. It is better and greater in reward. And seek forgiveness of Allah. Indeed, Allah is Forgiving and Merciful.” (QS. 73: 20)

In the view of the jurisprudent scholars (jurists) mudharabah is an agreement between two parties that one party was issuing amount of money to other party for trade and profits split according to the agreement. Mudharabah is equivalent to equity financing in conventional banking. It is a profit sharing contract that is entered between Islamic bank and investor. Bank is the funds owner while the borrower (investor) will be the working partner.

The borrower will approach to bank through a trading venture in which they will require a certain amount of investment. The bank, therefore, provides principle capital into the venture while the borrower takes full charge of managing this venture for the purpose of maximizing its profit and to liquidate all its properties by its closing date.

Musharakah is derived from word syarikah which means mixing. Islamic jurisprudence scholars define musharakah as contract for people associated in capital or profit. The profit will be shared based on the earlier

agreement parties before they start the business. When the loss happen, the loss will be shared together according to the capability of each party. In general, musharakah is joint venture in starting business with profit sharing based on the agreement from the parties that join. (Muhammad, 2011)

According to Antonio (2001), musharakah is a partnership contract from two parties or more to form a certain business where each party should contribute their capital, and the profit or loss will be shared according to the agreement that the parties made. Musharakah is also an example of equity financing. Unlike mudharabah, this contract is a joint venture in which the bank and investor share in both the profits and losses from the venture. The parties to this contract are Islamic bank and borrower. The borrower ask the bank to have partnership with them for a business. The bank & borrower provides a certain amount of capital. The borrower will get the responsibilities to manage the business and the bank also has the right to appoint an employee as a representative in the partnership.

Murabahah is an activity of selling goods with the seller telling the price to the buyer, amd then the buyer pay the price more than what the seller said as profit. (Dewan Syariah Nasional). According to Rifa’I (2002), murabahah in the Islamic banking concept is a purchase of goods in the original price with additional profit in agreement. In murabahah purchasing, the seller or the bank should inform the product price they bought and determine the profit as additional. This contract can be used as contract to buy

consumption goods or goods for business (providing capital) that the payment can be done in installment.

Monzer (1975) also explains ijara as a leasing contract. The bank purchases goods then leases them to the clients for specified rentals for a fixed period of time. Further arrangements can be made if the client wants to purchase the goods. In this contract, the Islamic bank is the lessor and the bank client is the lessee. The contract outlines are consist of the description of the asset to be leased, the amount of rentals charged for leasing the asset, the due date of submitting rentals and the whole period of the rent. The lessor is responsible for major maintenance that restores the leased asset to normal use in case of any deficiency; defect, unless such defect is caused by improper use by the lessee.

Istisna is a contract to manufacture goods, assemble or process them, or build a house or other structure according to the exact specifications and in a fixed timeline. Payments are made when property work property has finished. Financing istisna can only be done by means of two parallel contracts whose subjects are exactly similar: First contract is between the financier and the party that needs contracted things. Second contract is between the financier and the contractor who actually manufactures, constructs or builds the contracted things.

In conventional banks, the loan contracts are always include the interest, but in Islamic bank, the loan contract is should 100% interest-free. It is one kind of contract to help people continue their life or to start their own business. The interest-free loan contract name is qard or qard al-hassan.

Qard al-hassan is non profitable loans (zero-return). Al-qur’an really recommend all muslims to give loans to people in needs. The borrower only required to return for what they borrow, but they were allowed to add some bonus but as their own will. The borrower with qard al-hassan contract also got benefit from the financial services and moral support given by the bank. The return of the money is in a period agreed from both sides. Bank can take the service cost, but should not related with amount and period of the loans. So, the additional cost is only for the service that provided by the bank. Qard al-hassan become a way to strengthen and facilitate the business relations (Lewis and Algaoud, 2001).

In epistemological means, qardhul from the word of qard which means as “to cut”. It means the wealth has been cut when given to the borrower. From the hadits, giving loans with qard is more please Allah rather than giving sadqah. This is true and no need to doubt it. It is Sunnah from Rasulullah and Ijma’ from ulama (Maslehuddin, 1994).

In terminological means, qard al-hassan (benevolent loan) is a loans that given by social purpose only. In this case, the borrower does not required to return the additional money, except the amount of debt (Perwataatmadja and Antonio, 1999). Qard al-hassan is not a contract for financial profit purpose (Antonio, 2001).

In many places of the Holy Qur'an, Allah has mentioned and encouraged qard al-hassan by assuring better reward in this world and in the hereafter. As Allah says in Qur’an:

1. He who will give Allah qard al hasan, which Allah will double into his credit and multiply many times. [Al-Baqarah (2): 245]

2. If you give Allah qard al hasan. He will double it to your credit and he will grant you forgiveness. [ Al-Tagabun (64):17]

3. And give Allah qard al hasan. [ Al-Maidah (5): 12]

4. And give Allah qard al hasan, it will be increased manifold to their credit. [Al-Hadid (57): 18]

5. Who is he that will give Allah qard al hasan? For Allah will increase it manifold to his credit. [Al-Hadid (57):11]

6. Establish regular prayer and give regular charity and give Allah qard al hasan. [Al Muzzammil (73): 20]

The Sunnah of the Prophet [pbuh] is also very clear stated on this issue: Abu Amama said that the Prophet [pbuh] said: "In the night of the journey, I saw on the gate of heaven written, 'reward for sadqah (charity) is ten times and reward for qard hasan is eighteen times'. So, I asked the angel, how is it possible? The angel replied, "Because a beggar who asked might have already had something but a loanee did not ask for loan unless he was in need." [Ibn Majah and Ibn Hisham]

The hadis describe qard al-hassan is one act of charity to help the others because people who ask for loan is people who already in a very need. Furthermore, the reward of qard al-hassan is greater than sadqah, it means that qard al-hassan is an action that worth to do to help the others.

Abu Hurayrah said, the prophet of Allah [pbuh] said, “On the Day of Judgment, Allah will say: O son of Adam, I was sick yet you did not visit me. He will reply, O Allah, how could I have visited You since You are Lord of the Worlds? Allah will say: Did you not know that so-and-so a servant of Mine was sick, and yet you did not visit him? Did you not realize that if you had visited him [I would be aware of this, and would reward you] and you would have found me with him? O son of Adam, I asked for food from you but you did not feed me. He will say: My Lord, how could I feed you since You are the Lord of the Worlds? Allah shall say: didn’t you know that so-and-so a servant of Mine asked food from you but you did not feed him, did you not realize that had fed him you would certainly have found [its reward] with Me? O son of Adam, I asked water from you but you did not provide Me with water. He will say, O Allah, how could I have provided you [with water] when You are Lord of the Worlds. Allah will say: so-and-so a servant of Mine asked you for water to drink but you did not provide him with water. Did you not realize that had you pr Surah ovided him with water to drink you would have found [its reward] with me?” [Sahih Muslim]

The hadis explain concerning sharing to others is similar to give something to Allah, and Allah will rewards us something. The people who ask us food or water is a servants from Allah to let us have a chance to give food and water to others.

In another hadis reported by Abu Hurairah (R), the Prophet [pbuh] said, "whoever relieves a believer from a difficulty in this world, Allah will relieve him from his difficulty and Allah will facilitate him in this world and world hereafter." [Muslim].

From the hadis above, we can understand that a charity act is something that won’t give us any difficult at all, but in reverse it will give us easiness in everything and it is what Allah said. Currently, qard al-hassan has been focused on introducing qard al-hassan as a financial, humanitarian, and welfare tool that can solve problem about inequalities and control the wealth in societies by helping the poor and the people that in disadvantage (Farooq, 2010; Obaidullah and Tariqullah, 2008; Khan, 2008; Mojtahed and Hassanzadeh, 2009; Najeeb and Lahsasna, 2012). These contemporary studies

have set up the role of qard al-hassan on improvement of the human condition through religious way as well as the historical data collected from various countries in the past couple of decades. The concept is mostly used in providing microfinance by NGOs, charities, religious organizations, etc. The results have not been good enough in reducing poverty, improving conditions and gaining popularity among Muslim communities due to several reasons (Khan, 2008).

According to Widiyanto et al (2011), providing qard al-hassan financing to the poor cannot solve the poverty problem on its own and requires better way which involves broader aspects such as education, information and morality. Extending financing through qard al-hassan has been insufficient and inefficient in solving the poverty problem because the lack of ability to profit, high administrative and transaction costs, high risk and lack of demand from the users (Ariffin and Adnan, 2011). To decrease losses and added capital to qard al-hassan, several researchers have recommended using charities and donations related with qard al-hassan, the problem regarding lack of funding can be solved afterwards (Ahmed, 2007; Febianto and Ashany, 2012). According to Farooq (2007), one of the advantages of qard al-hassan funding is that the source of financing can be emerge from the local community so that the qard al-hassan financing model does not rely on the government or commercial sources. Rather than focuses on developments in individual practices of charities and donations, there is much work remaining in terms of putting these pieces back into a whole system to identify social economic problems (Ahmed, 2007).

Qard al-hassan is a product of Islamic bank, which there are many other products in Islamic bank, but qard al-hassan got a special function where this contract is a contract that got social function to the society as a help to the people who doesn’t have money and they want to borrow it from the Islamic bank. The Islamic banks bring their business on the basis of equity-participation (musharakah, and muqarabah), leasing (ijarah), lease-purchase (ijarah wa iqtina '), cost-plus financing, (bay' murtiba~ah), and rent-sharing. These institutions have also innovated in planning some new financial instruments like Participatory Term Certificates (PTC), Term Finance Certificates (TFC), Muqaraqah Bonds, Leasing Certificates, etc (Khan, 1994). Banks and other financial intermediaries are the main source of external funds to firms. Intermediaries provided more than 50 percent of external funds that happened from 1970 to 1985 in the United States, Japan, the United Kingdom, Germany, and France (Mayer, 1990). Contrary, Islamic bank got their role as intermediaries. A financial intermediary is a risk neutral agent, with personal wealth equal to zero. The intermediary receives funds from depositors to lend to entrepreneurs and is entrusted the task of monitoring the outcomes of entrepreneurs' projects on behalf of depositors (Diamond, 1984).

As intermediaries, Islamic bank help people to get their capital or just to get money to continue their lives. There are many Islamic contract that makes the bank being intermediaries, in example qard al-hassan contract. In qard al-hassan contract, banks use the saving money in Islamic bank, to lend the borrower. In this case, the banks become intermediaries for the investor or

people who save their money in the Islamic bank and the borrower with qard al-hassan contract. While the bank doing their function as financial intermediary and running their business, there are many risk that appear corresponding with the contract that provided by the Islamic bank.

Risk financing is a risk happened cause from other party could not fulfil their responsibility to pay. Risk financing can happen by bank activities likes financing, treasury and investment, and trade finance funds that noted inside banking book or trading book (Veitzal, 2007).

By providing this kind of contract, the Islamic bank got their role in helping peoples. Besides that, Islamic bank also has a commercial purpose to keep the business exist. According to those purpose, profitability of Islamic bank is an important thing to keep it on the good condition because if it doesn’t, then it will become a sign to that Islamic bank that they should do their job better than before and for the worst case, it can cause a closure to that bank.

The performance of commercial banks can be affected by internal and external factors (Al-Tamini, 2010; Aburime, 2005). Profit is the ultimate goal of commercial banking (Ongore & Kusa, 2013). It is important to measure the financial performance of a bank as a means of knowing the progress of the bank and the managers and shareholders are able to tell how the bank is doing.

Banks rely on the use of financial ratios to achieve this. To measure profitability of commercial banks, a variety of profitability ratios are used of which, return on equity (ROE), return on assets (ROA), and net interest margin (NIM) are the major ones (Murthy & Sree, 2003, Alexandru et al, 2008). Those are some of the bank performance indicators.

The ROE is measured the efficiency of a company employs the owner’s capital (Khrawish, 2011). It is a financial ratio refers to how much profit a company earned compared to the total amount of shareholder equity invested or found in the balance sheet (Ongore & Kusa, 2013). It is calculated as follows; Net income/ Bank capital. The better ratio of ROE, the higher the profitability of the bank and the more effective management utilized by shareholder capital.

The ROA is a ratio of income to its total assets (Khrawish, 2011). It measures the ability of bank management to generate income by utilizing company assets at their disposal (Ongore & Kusa, 2013). ROA is measured by; Net income/ Bank assets. Wen (2010), states that a higher ROA shows more efficient in using company’s resources.

Those two ratios, ROE and ROA, can be used when measuring the profitability of Islamic banks. The third ratio (net interest margin), cannot be used since Islamic bank principles prohibit the charging and receiving of interest. In general, the profitability of an Islamic bank can be seen from their return on assets (ROA) from their annual report or report from each month. From this factor, the profitability of the bank can be calculated and seen how

good they are or how bad they are in the business they were run. Return on assets is an indicator about how the profitability of the Islamic bank conditions related to their assets. It is used to identify how their business condition from the profit perspective.

The graph bellow is the return on assets (ROA) of Islamic Bank in Indonesia:

Figure 1.1 ROA of Islamic Bank in Indonesia

Data from: SPS year 2016

Figure 1.1 describe, the performance of Indonesian Islamic bank based on return on assets (ROA). The performance from January to July is decreasing, and moreover on April to May, ROA’s start increase from May to June. In this case, the return on assets (ROA) of Islamic bank in Indonesia doesn’t show any good result because the ROA on June is lower than the ROA on January in 2016. According to the previous research conducted by Hasan and Bashir (2003), the Islamic banks’ profitability measures respond positively to increase in capital and loan ratios.

0.20 0.40 0.60 0.80 1.00 1.20

1 2 3 4 5 6 7

Perc e n ta ge Month

Whereas from hypothesis of this research, the decreasing in performance of Indonesian Islamic bank caused by the Islamic contracts, because all the contracts had interest free.

For Islamic banks, the net income does not include interest income but rather income realized from financing activities (deals), other operating income and non-operating income. Income from financing activities refers to the mark up charged when offering financing contracts and the profit gained from equity contracts. The bank’s assets in this case majorly include the financing activities of the Islamic bank, unlike loans for conventional banks.

Each financing contract the bank offers contributes to the profit of the bank. The contract can either increase profitability or decrease profitability depending on their proportion to the overall financing activities of the bank. The return on assets (ROA) is an indicator to identify how a company do their business; are they profitable or not; and are they need to do something or just keep doing the business as it is.

In this research, researcher has an aim to study the influence of Islamic contracts with the profitability of Islamic bank, since Islamic contracts doesn’t have any interest.

1.2 Research Question

Based on the background of this research, there are some questions that appear and need answers, there are:

2. Does musharakah influence the return on assets (ROA) of Islamic bank? 3. Does murabahah influence the return on assets (ROA) of Islamic bank? 4. Does ijarah influence the return on assets (ROA) of Islamic bank? 5. Does istishna influence the return on assets (ROA) of Islamic bank? 6. Does qard al-hassan influence the return on assets (ROA) of Islamic

bank?

1.3 Research Objectives

Based on the research question, the Objectives of this research are:

1. To study the influence of mudharabah to the return on assets (ROA) of Islamic bank.

2. To study the influence of musharakah to the return on assets (ROA) of Islamic bank.

3. To study the influence of murabahah to the return on assets (ROA) of Islamic bank.

4. To study the influence of ijarah to the return on assets (ROA) of Islamic bank.

5. To study the influence of istishna to the return on assets (ROA) of Islamic bank.

6. To study the influence of qard al-hassan to the return on assets (ROA) of Islamic bank.

1.4 Research Benefits

The benefits which could be gained from this research are:

1. For society, this research would encourage people to use the Islamic contracts in Islamic bank without worrying whether it will affect the Islamic bank profitability or not.

2. For bank, this research will give information to the bank whether Islamic contracts are profitable or not, and also encourage the Islamic bank to provide these contracts because it will help the people who are really in need.

3. For academic environment, this research can be continued or re-research about the influence of Islamic contracts on profitability of Islamic bank.

1.5 Research Plan

In order to understand the undergraduate thesis clearly, so the researcher divided the materials into several sub-chapters with systematic writing as follows: Chapter I, Introduction; This chapter describes the general information that the research background, problem formulation, purpose and benefits of the research, the scope of research, time and place of study, research methodology, and systematic research. Chapter II, Theoretical Framework and Hypothesis; This chapter contains the theory that some excerpts taken from the book, in the form of understanding and definition. This chapter also explains the basic concepts of Islamic economics system, Islamic Bank, the main characteristics of Islamic banks, Islamic

contracts : mudharabah, musyaraka, murabahah, ijarah, istishna, and qard al-hassan, financial intermediaries, financial risk, financial performance, profitability, return on assests (ROA). Chapter III, Research Methodology; This chapter contains the definition of variables that used in this research, data and the source, the methodology of regression test analysis. Chapter IV, Research Findings; This chapter describes the influence of Islamic Bank Contracts to the return on assets (ROA) of Islamic bank in Indonesia. It also contains the result from the analysis of regression test, the result table and diagram, the analysis of empirical result with the theoretical framework and previous study. Chapter V, Conclusions; This chapter contains of conclusion from the research, suggestion for the policy maker of Islamic bank in Indonesia and suggestion for the next research.

CHAPTER II

THEORITICAL FRAMEWORK AND HYPOTHESIS 2.1 Theories

2.1.1 Islamic Economics System

Islamic economics considers human behavior in completely. It deals with human life as a whole which is consists of multiple mutually-reinforcing sub-systems. The economic sub-system is one of these sub-systems. It is not even the central sub-system. It affects the human behavior only from the border line. The hard core of the system is consists of the basic beliefs in the Unity of God, in the apostle-hood of Muhammad (peace be upon him) and in man's accountability on the Day of Judgement. These beliefs are the foundation of each sub-system (Khan, 1994).

Nowadays, economics system is one of the biggest concern in every country in this world, because from the economics system, they can decide how the country will develop and how they will face the problem that occurs in their countries. The economics system studies are always developing every days because until now, the scholars and researchers still doing their study about economics system to find the best economics system that can bring welfare to all people in the world.

In Islam, the economics system is a little bit different. The main concept of Islamic economics system is the prohibiting of riba or usury in the economics system. Islamic economics place human in a good place and really consider about the people welfare by believing that peoples should help each other to make the welfare turn in to reality.

Eradication of poverty, socio-economic justice and equitable distribution of income are among the primary goals of Islam and should be unyielding features of an Islamic economic system (Chapra, 1985). In Islamic economic system itself, alleviating poverty is a big concern, however to apply the Islamic economic system as a whole system is a difficult task to do, the problem regarding poverty still exists recently. Otherwise, the justice and income equality problem have not completely solved. The financial instrument in Islamic finance got some problem as creating new debt to the people, and people could not pay their debt, it keep happens.

Islamic finance as the operational framework of Islamic economics has criticized for its apparent over-reliance on debt-based financial instruments, such as murabahah and ijara (leasing), it is represent as a consumer-debt industry where the end of result does not contributes to the socio economic and developmental objectives of its founding fathers (Chapra, 1985; Asutay, 2008). In the investment, Islamic economics system also got their role as a help to people who want to start their business getting their funds and giving place for people who got more money to invest their money in Islamic way. It is a

help for micro-finance and also for the government to increase the national income or to enhance the development of micro-finance.

Islamic micro-finance can be defined as the investment of capital (in cash or in kind) based on Islamic methods of finance to poor entrepreneurs in order to help them start or maintain their businesses (Smolo, 2007). Thus on these basic assumptions Islamic economics has a different position. This provides, in part, need and justification for a separate methodology of Islamic economics. This is not a contention that the process of criticism and rational examination of economic theories itself is questionable. It only means that economics does not have any hard core of sure knowledge which may be treated as a point of reference and criteria for judging the truth and falsity of various theories. Therefore, there is a need for a methodology which not only provides basis for sure knowledge but also eliminates confusion of contradictory theories by laying down a criterion for judging the contending theories. Since mainstream Islamic economics is divine knowledge, it cannot accept a methodology which relies only on human knowledge (Khan, 1987).

With the basic concept of Islamic economics system that was interest-free system, the interest-interest-free system is a must for every economics activity included contracts or product that provided in the Islamic bank.

2.1.2 Islamic Bank

Islamic banking movement show up again coincide with the establishment of the Islamic Development Bank (IDB) in 1974 by the Organization of Islamic Countries (OIC), which has been considered as the starting for the second phase movement (Abdel-Haq, 1989). A large number of Islamic banks were established not only in Muslim countries, but have also start established in non-Muslim countries. Some Islamic banks that established in 1970s are Dubai Islamic Bank (l975), Faisal Islamic Bank of Egypt (l977), Faisal Islamic Bank of Sudan (l977), and Bahrain Islamic Bank (l979) were the first era Islamic bank that established in Muslim countries. The Islamic Finance House in Luxembourg was established in 1978 to represent the first attempt at Islamic banking in Western world (Ariff, 1988), followed by the first Shariah-compliant insurance company (takaful) in 1983 in Luxembourg as well (Derbel et al., 2011). Many traditional Western banks have established Islamic windows / branches such the HSBC Bank, ANZ Grindlays, Standard Chartered Bank, Barclays, Citibank, ABN AMBRO, Klienwort Benson, Merrill Lynch, Midland Montagu, and Goldman Sachs (Khan, 2000; Hassan and Ahmed, 2002). Some Islamic countries such as Iran and Sudan have fully Islamized their banking systems during the eighteenth and nineteenth of the previous century (Sundararajan and Errico, 2002).

Islamic financial institutions have taken the form of commercial banks, investment banks, investment and finance companies, insurance companies, and financial service companies. The banking sector, in particular, follows

different banking models, such as private institutions in a conventional economy (as in the most of Arab countries and the West), dual banking models (as in Malaysia), Islamic subsidiaries of conventional banking groups, and Islamic banking windows within conventional banks. With annual growth rates of 15-20% on average over the last five years, the Islamic finance market represents an international segment recording the fastest growth in the finance sector (Derbel et al., 2011). During the last three decades, the number of Islamic financial institutions has risen from one institution in one country in 1975 to over 300 institutions operating in more than 75 countries worldwide (El Qorchi, 2005). These institutions are managing funds of around US$200 billion, with total assets of more than US$822 billion (Iqba and Molyneux, 2005; Moin, 2008).

With the basic concept of Islamic economics system, the Islamic bank also apply the interest-free system. It means the interest that usually used in any contract in conventional bank, in Islamic bank is not allowed or it is absolutely prohibited. The interest-free system in Islamic bank is a help for poor people to get the product from the Islamic bank to start or to enhance their economic activities because they don’t required to pay additional money from what they get.

The idea of Interest-free banking was introduced in the late of 1940s by Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952). The first modern experiment with Islamic banking was established in a small town in Egypt, called Mit Ghamr, in 1963 by Dr. Ahmed El Najjar. The bank

took the form of a saving-investment bank based on profit sharing and free interest, rather than commercial bank (Ariff, 1988; Siddiqi, 2006).

According to Iqbal (1997), the economic development of Islamic countries can be greatly enhanced by the Islamic financial system due to the mobilization of savings that are being kept away from interest-based banks and the development of Islamic capital markets. This motivation to invest in Islamic banks may also stem from the fact that research shows the share in the banks’ profit may at time be higher than the fixed rate of interest given by conventional banks.

Even Iqbal and Molyneux (2005) are of the opinion that Islamic banking promotes innovation by financing anyone who has a good idea. If a small and medium entrepreneur has a better project, he has the possibility of getting financed and he will not be held back by the fear of tremendous risk since innovation involves a huge risk. Islamic banking system results in a better risk distribution since the risk is distributed between the financier and the entrepreneur.

Economic development requires effective and efficient mobilization of financial resources both internally and externally and any resource left hoarded indicates unrealized potential for economic development. For Kahf (1999), the focus of Islamic finance on profitability and rate of return of investment due to equity and profit sharing has the potential of directing financial resources to the most productive investment and hence increases the efficiency of resources allocation. However, the adoption some elements of the Islamic financial

system, which are also part of the western heritage, and indispensable for ensuring the health and stability on the global financial system.

Ali (2011) argues even the credit types of Islamic financing, like murabahah and ijara transactions, which provide credit against usufruct or tangible asset, required Islamic banks to know the client’s purpose and the use of finance. These modes also require ownership of the asset by the bank, albeit for shorter duration in case of murabahah and longer duration in case of ijara finance. This increases the likelihood (or ensures) that the funds are used for their stated purposes. Thus, keeps credit tied to real economic activity for each transaction and throughout the tenor of contract. In conventional bank financing the client is not required to disclose the use of funds as long as the client is believed creditworthy or can post suitable collateral. This ownership of the financed asset by banks can help them in credit risk mitigation. In addition, it curbs the roll-over of the credit which may lead to the ballooning of debt and credit which may delink the financial sector from the real sectors.

It also has been observed for small manufacturers and farmers, as compared with larger production units, face much greater difficulties in obtaining short, medium and long-term credit through institutional channels. The major constraint to access to finance was the lack of tangible collaterals.

Abdouli (1991) argues that Islamic banking breaks this discriminative barrier and offers an equal opportunity to all potential producers by taking intangible assets, such as education, skills, and experience as collateral as tangible assets. Islamic banking would contribute to the emergence of a just

and growing economy by enabling small enterprises to obtain finance on participatory basis in which collateral is not necessary. He argues that the common practice of western banking institutions of granting credit facilities only to those who are able to offer sufficient tangible collateral security, would rather deteriorate the already uneven income distribution between upper and lower classes. Because of the nature of its operations, Islamic banking does offer a new dimension in lending. Since it is a system based on participatory financing, Islamic banking would not depend on tangible collaterals as much as western/conventional banks. Such access of finance not totally dependent on wealth endowment, would eventually lead to a better distribution of income and a larger improvement in the well-being of those who for none of their fault were endowed with niggardly resources.

Moreover, El-Ghattis (2011) argues in contrastly to conventional methods of financing, Islamic financing is not centered only around creditworthiness of the client but rather on the worthiness and profitability of the project to be financed. Therefore recovering the principal becomes a result of profitability and worthiness of the actual project. The Islamic profit sharing concept helps to foster economic development by encouraging equal income distribution, which results into greater benefits for social justice and sustainable growth. The profit and loss sharing (PLS) scheme improves capital allocation efficiency as a return on capital depends on productivity and profitability of the financed project.

The profit and loss sharing based financing encourages entrepreneurial activities by removing the injustice caused by interest-based financing which makes the entrepreneur responsible for every loss happens to his project. PLS distributes risk in a fair manner that encourages venturous entrepreneur to take more projects with the same level of risk-taking attitude he/she already has. For Kahf (1999) entrepreneurship and risk sharing are therefore promoted by Islamic finance and its expansion to the poor members of the society is an effective development tool. The social benefits are clear, as currently the poor are often exploited by financial institutions charging usurious rates. This sharing principle is very different to traditional banking practices. It introduces the concept of sharing to financing and creates a performance incentive within the mind of the banker that relates deposits to their performance in the use of fund. This increases the deposit market and gives it more stability.

2.1.3 Islamic Contracts

Various forms of commercial contract in Islam can be identified in the Qura’n (Ajlouni, 2012). Islamic contracts of relevance to commercial and financial activity are widely recognized as contracts of exchange, contracts of charity and contracts of investment and partnership. According to Ahmed and Zakaria (2011), it is generally agreed, commercial transaction should be concluded at a price that is agreed mutually and not under duress.

Islam generally permits trade and commerce, therefore civil contracts can be used in Islamic banking and finance. Brown (2003), defines the concept

of Islamic banking and finance and mobilization of deposits through contracts by shariah and application of funds through contracts permissible by the shariah. According to Chachi (2005), the concept of Islamic banking was developed in late 1940s, based on the norms and standards of Sharia law. Islamic financial contracts are the basis for the operations of Islamic banks and it also has the same importance to the conventional banks which offer shariah compliant products (Faraq, 2010).

2.1.3.1 Mudharabah

Mudharabah (finance by way of trust) is a form of partnership in which one partner (rabb al-mal) finances the project, while the other party (mudarib) manages it (Gamal, 2006). According to Gamal, mudharabah though similar to musharakah, has a financing mode, does not require that a company be created, the financial institution provides all of the capital and the customer is responsible for the management of the project. Profits from the investment are distributed according to a fixed, pre-determined ratio.

Mudharabah is equivalent to equity financing in conventional banking. It is a profit sharing contract that is entered between the Islamic bank and the investor. The bank is the funds owner while the borrower (investor) will be the working partner. The borrower will approach the bank with a trading venture in which they will require a certain amount of investment. The bank therefore provides principle capital into the venture while the borrower takes full charge

of managing this venture for the purpose of maximizing its profit and to liquidate all its properties by its closing date. The bank has the full right to inspect accounts, books and records of the venture at any time and place a reservation on any managerial acts it sees unfit in the best interest of the venture. This input is important since the bank is taking all the risk. The profits are shared at a predetermined ratio whereas any losses made are borne by the bank. Losses incurred due to indiscretions by the borrower will be borne by the borrower and not the bank (Monzer, 1975).

2.1.3.2 Murabahah

Monzer (1975) explains that murabahah is the equivalent to asset financing in conventional banking. It is a cost plus mark up contract. The parties to this contract are the Islamic bank and the borrower. The borrower will approach the bank to buy an asset on their behalf from a supplier in a predetermined price upfront. The bank will then carry out its own due diligence before agreeing to take up the contract.

Once the contract is approved, the bank will purchase the asset and the borrower will be given a period of time to pay the bank for the asset at a price which will include the asset price plus a markup profit for the bank. This mark up is determined before the asset is bought and the borrower is made aware. The assets can be used as collateral for the transaction or the borrower can provide another form of collateral. The borrower can pay in predetermined installments the whole amount owed (cost plus mark up).

In murabahah contract, the bank agrees to buy an asset or goods from a third party, and then resells the goods to its client with a mark-up (Iqbal, 2011). The client purchases the goods against either immediate or deferred payment.

2.1.3.3 Musharakah

Musharakah (partnership) which according to Gamal (2006), is often perceived to be the preferred Islamic mode of financing, because it adheres most closely to the principle of profit and loss sharing. Partners contribute capital to a project and share its risks and rewards. Profits are shared between partners on a pre agreed ratio, but losses are shared in exact proportion to the capital invested by each party.

Musharakah is also an example of equity financing. Unlike mudharabah, this contract is a joint venture in which the bank and investor share in both the profits and losses from the venture. The parties to this contract are the Islamic bank and the borrower. The borrower approaches the bank to go into partnership with them on a trading activity. The bank provides a certain amount of capital and the borrower also contributes a certain amount of capital. The borrower will assume all managerial responsibilities but unlike in mudharabah, the bank has the right to appoint an employee as a representative in the partnership. The profits and/or losses that come about as a result of the partnership are shared according to a predetermined ratio. The borrower will put under full authority of the bank their securities, assets as a guarantee to be

used only in the case of damage caused by neglect or transgression by the second partner (Monzer, 1975).

2.1.3.4 Ijara

Ijara(leasing) contract, similar to a conventional lease, is the sale of manfa’a (the right to use goods) for a specific period. In Muslim countries, leasing originated as a trading activity and later on became a mode of finance. ijara is a contract under which a bank buys and leases out an asset or equipment required by its client for a rental fee (Hassan & Mervyn, 2009).

Monzer (1975) explains ijara as a leasing contract. The bank purchases goods then leases them to the clients for specified rentals for a fixed period of time. Further arrangements could made if the client wants to purchase the goods. In this contract, Islamic bank is the lessor and bank client is the lessee. The contract outlines are about the description of the asset to be leased, the amount of rentals charged for leasing the asset, the due date of submitting rentals and the whole period of the rent. Lessor is responsible for major maintenance restores leased asset to normal use in case of any deficiency; defect, unless such defect is caused by improper use by the lessee. The lessor is also responsible for insurance on the asset itself. The lessee is responsible for regular operational maintenance and for any defect caused by harsh, and/or abnormal use of the asset. At the end of the rent period, the lessee shall return the leased asset to the lessor. In the case where the lessee is willing to purchase the asset after the rent period lapses, the contract parameters change slightly in

that, in addition to paying rentals monthly, the lessee will also pay a certain amount that will contribute into the total price for the asset. Thus, the lessee will be saving up towards buying the asset. This amount is agreed at the onset of the contract.

2.1.3.5 Istisna

Istisna (commissioned manufacture), although similar to bai bi-thamin ajil transactions, istisna offers greater future structuring possibilities for trading and financing (Mohammad & Melvis, 2015). One party buys the goods and the other party undertakes to manufacture them, according to agreed specifications. Islamic banks frequently use istisna to finance construction and manufacturing projects.

Istisna is a contract to manufacture goods, assemble or process them, or build a house or other structure according to the exact specifications and in a fixed timeline. Payments are given when work on property is finished. Financing istisna can only be done by two parallel contracts whose subjects are exactly similar: first contract is between the financier and client. The second contract is between the financier and the contractor who actually manufactures the goods. The client approaches the bank to finance the manufacture of an asset. Then, bank approaches contractor to carry out the manufacturing. Bank pays the contractor after delivered of manufactured goods. The full price paid out plus a markup profit are added up and submitted to the client. The client

pays the bank back in installments. The client delivers assets to be held as collateral until full repayment (Monzer, 1975).

2.1.3.6 Qard Al-hassan

According to Bank Negara Malaysia concept paper, the definition of Qard refers to a contract of lending money by a lender to a borrower where the latter is bound to return an equivalent replacement amount to the lender. Money may include cash, all forms of currency, gold and silver. A qard contract is established when the ownership of a sum of money belong to lender is transferred to the borrower which gives effect the borrower to have an obligation to repay the lender in full. The inherent nature of a qard contract is the obligation of the borrower to return the money borrowed in full. Terms and conditions of the qard contract that have been mutually agreed upon between the contracting parties and consistent with the Shariah must be binding on the contracting parties. Qard contract must consist of the following components: (a) contracting parties, comprising lender and borrower; (b) offer (ijab) and acceptance (qabul); and (c) money.

The parties in a qard contract must be a lender and a borrower (collectively referred to as “contracting parties”). The lender must be the owner of the money to be lent to the borrower under the qard contract. The contracting parties must be a natural person or a legal entity that must have the legal capacity to enter into the qard contract. Any party to the qard contract may enter into the contract through an agent (wakil). It should recognized through

an offer and acceptance of contracting parties. The offer and acceptance may be expressed orally, in writing or by any other methods which could be evidenced by appropriate documentation or record. Moreover, it should involve a subject matter which is fungible, deliverable and recognised by the Shariah. This refers to money, include cash, all forms of currency, gold and silver. The subject matter in a qard contract have to be guaranteed by the borrower to the lender at all times and in all circumstances including against loss or damages. The qard contract shall not result in any form of contractual benefit to the lender merely for lending money. This includes: (a) execution of contracts for sale of assets conditional on the purchaser borrowing money from the seller; (b) pre-agreed periodic rebate (ibra’) to the purchaser on the instalment of a deferred selling price which is linked to the qard contract from the purchaser to the seller; (c) any form of incentives promised to a lender to enter into a qard contract; or (d) hibah given by the borrower to the lender in the form of cash, in kind or benefit that is conditional to the qard contract. Any rebate (ibra’) in settling the full selling price of the sale contract are allowed. Such rebate (ibra’) must separate from the qard contract. The borrower under a qard contract must not give hibah to a lender, in the form of cash, in kind or benefit that is conditional to the qard contract. The granting of hibah by the borrower to the lender is only allowed when it is solely based on the borrower’s discretion. The borrower must not disclose, promote or market the indicative rate or prospective payment of hibah. The borrower must not use historical information on the payment of hibah to promote or market qard. A borrower

may disclose historical information on the payment of hibah for purpose of market transparency. The general services, facilities or incentives may be charged with a fee (ujrah). Examples of such benefit include internet access to e-payment solution, system infrastructure and cash management services. The borrower must be entitled to any benefit or revenue gained from the money borrowed.

Source of money for qard contract, the borrower is not obliged to ascertain the source of money provided for the qard contract. The borrower may accept the qard without any knowledge of the source of such money. When the borrower has the knowledge, the source of the money used for the qard is not Shariah compliant, the borrower must not accept such money. Relevant authority may, on the ground of public interest, exempt acceptance of money acquired or generated from Shariah non-compliant activities under specific circumstances.

Sources for micro-financial institutions could be many and varied, but some of the most popular sources of funds for these include zakat (Almsgiving), sadaqa (Charitable giving), awqaf (Charitable endowments) and qard al-hassan (Benevolence loan) (Obaidullah, 2008). Qard al-al-hassan is a credit that is paid back at the closing stages of the agreed upon load period which the borrower is not engaged in any interest or profit and loss of the loan (Chapra, 1995).

2.1.4 Financial Intermediaries

Financial intermediation is a pervasive feature of all of the world’s economies. But, as Allen (2001) observed in his AFA Presidential Address, there is a widespread view that financial intermediaries can be ignored because they have no real effects. They are a veil. They do not affect asset prices or the allocation of resources. As evidence of this view, Allen pointed out that the millennium issue of the Journal of Finance contained surveys of asset pricing, continuous time finance, and corporate finance, but did not survey financial intermediation. Here we take the view that the savings-investment process, the workings of capital markets, corporate finance decisions, and consumer portfolio choices could not be understood without studying financial intermediaries.

Boyd and Prescott (1986) assert that financial intermediaries lend to agents whose information set may be different from their own, in particular, would-be borrowers have private information concerning their own credit risk. Although this suggests a clear role for intermediaries, it is not clear that this is a necessary condition.

A financial intermediary obtains funds from lenders and lends them to entrepreneurs. Economists have tried to explain this intermediary role by arguing the financial intermediary has a cost advantage in certain tasks. When such tasks involve unobserved actions by the intermediary or the observation of private information, then, an agency/in-centive problem for the intermediary may exist. Any theory which tries to explain the role of intermediaries by an

information cost advantage must net out the costs of providing incentives to the intermediary from any cost savings in producing information. Existing intermediary theories do not make this final step. We now introduce a financial inter-mediary between entrepreneurs and lenders (whom we call depositors from now on), and examine conditions when this intermediary function is viable considering all costs (Diamond, 1984).

A financial intermediary is a risk neutral agent, with personal wealth equal to zero. The intermediary receives funds from depositors to lend to entrepreneurs and is delegated the task of monitoring the outcomes of entrepreneurs' projects on behalf of depositors (Diamond, 1984).

Banks and other financial intermediaries borrow in order to lend. Since the loans offered by banks tend to be longer maturity than the liabilities that fund those loans, the term spread is indicative of the marginal profitability of an extra dollar of loans on intermediaries’ balance sheets (Adrian and Shin, 2009).

Dridi and Hasan (2010) also asserted that there was a difference in terms of financial intermediation between Islamic and conventional banking. The central concept in Islamic banking and finance is justice, which is achieved mainly through the sharing of risk. Stakeholders are supposed to share profits and losses because of the prohibition of interest in Islam. While conventional intermediation is largely debt based, and allows for risk transfer, Islamic intermediation, is asset based, meanwhile centers on risk sharing. One key difference between conventional banks and Islamic banks is that the latter’s

model does not allow investing in or financing the kind of instruments like bonds, derivatives and toxic assets which have adversely affected their conventional competitors and triggered the global financial crisis.

2.1.5 Financial Risk

Errico and Farahbakhsh (1998) for instance point out that prudential supervision and regulations governing Islamic banks should place a greater emphasis on operational risk and information disclosure. They explain the special risks attached to PLS. For instance, in certain cases Islamic banks cannot mitigate credit risk by demanding collateral from clients, as their relationship is established on the basis of partnership; moreover, they do not have enough control over the management of projects financed in the form of Mudharabah.

Khan and Ahmad (2001) claim the sharing Islamic banks’ profit or loss with their investment account holders could introduces withdrawal risk. They also argue that different Islamic modes of finance have their own unique risk characteristics due to the various constraints enforced by Shariá (Islamic rules). Sundararajan and Errico (2002) suggest the complexities of PLS modes of finance and the risks associated with the non-PLS activities should be taken into account to establish more effective risk management. They also point out various moral hazard issues which occur as a result of the special relationship between Islamic banks and investment account holders.

Obaidullah (2005) argues deposit withdrawal risk may persuade Islamic banks to deviate from traditional Shariá financing principles. This occurs when banks pay competitive market returns to investment account holders regardless of the bank’s actual performance.

The case where religious factors lead to lower withdrawal risk for investment account holders may influence Islamic banks’ lending behavior. It may weaken their incentives for due diligence and loan monitoring, since Islamic banks can transfer credit risk to investment account holders who do not have the same rights as equity holders but share the same risk (Sundararajan and Errico, 2002).

To measure risk, the majority of the empirical banking literature uses accounting-based ratios that are related to credit and/or liquidity risk, and mainly include the ratio of (i) non-performing loans to total loans and (ii) loan-loss provisions to total loans, and (iii) the ratio of risk-weighted assets to total assets (Casu et al., 2006).

2.1.6 Financial Performance

Performance is the description of the achievements of companies in the operational activities related to financial aspects, marketing aspects, aspects of fund raising and distribution, technological aspects, as well as aspects of human resources (Jumingan, 2006).

According to Gitosudarmo and Basri (2002) financial performance is a series of financial activity in a given period that are reported in the financial statements including income statements and balance sheets. Moreover, Sucipto (2003), describe financial performance as the determination of a certain measurement that can be measured the success of an organization or company in generating profits. Meanwhile, financial performance is the description of the company's financial conditions at a given period concerning aspects of fund raising and distribution of funds, which is usually measured by indicators of capital adequacy, liquidity, and profitability (Jumingan, 2006).

According to Mulyadi (2007) financial performance is the determination of periodic operational effectiveness of an organization and its employees based on the objectives, standards and criteria established earlier. A similar opinion was expressed by Sawir (2005) which states that financial performance is a condition that reflects a company's financial situation based on the goals, standards and criteria. Also, according to IAI (2007), the financial performance is the company's ability to manage and control its resources.

The company's performance is a picture of the financial condition of a company that analyzed the financial analysis tool, so it can be known whether the poor financial condition of a company reflects performance in a particular period. It is very important to understand the resources are used optimally in the face of environmental change. Financial performance assessment is one way that can be done by the management in order to meet its obligations to funders and also to achieve the goals set by the company. Performance can be

defined as the achievements of companies in a given period which reflects the level of health of the company (Sukhemi, 2007).

According to Fahmi (2011) financial performance is an analysis done to identify to what extent the company has conducted the rules of financial performance. Financial performance is a measurement for a firm or bank about how good they use the assets and gaining profit. This measurement also used to identify the financial health of the firms or banks. Some factors used for measuring the financial health are the profitability of the firms or banks or in this paper used return on assets (ROA).

Financial performance is an overview of the company's achievements can be interpreted as the results achieved over the various activities that have been performed. Financial performance is an analysis done to identify to what extent the company has been implementing the operational rules (Fahmi, 2012).

Performance in accounting terms is the quantification of effectiveness in the operation of the business during a certain period. The bank's performance in general is an achievement reached by the bank. The financial performance of the bank is the description of the bank's financial condition at a particular period includes aspects of fund raising and distribution of funds. Performance shows something related to the strengths and weaknesses of a company.

From some understanding of the financial performance above, it can be concluded that financial performance is the achievement of the company in a

period which describes the condition of the company's financial health with using indicators of capital adequacy, liquidity and profitability.

2.1.7 Profitability

According to Harahap (2002), the profitability of a company's ability to generate earnings for a certain period. While according to Husni (2011) the internal determinants of banks profitability are normally consisting of factors that are within the control of commercial banks. They are the factors which affect the revenue and the cost of the banks. Some studies classified them into two categories namely the financial statement variables and non-financial variables. The financial statement variables include factors that are directly related to the bank’s balance sheet and income statement. Whiles, the non-financial statement variables include factors like the number of branches of a particular bank, location and size of the bank, etc (Haron, 2004).

Rasiah (2010) claims that the use profitability ratios are not influence by changes in price levels. Moreover, Rasiah (2010), presented that banks generate income mostly on their assets and the assets could be termed as income and non-income generating. With regards to commercial banks income, Rasiah (2010) classified into two, namely interest and non-interest income. The interest income consist of rates charge on loans, overdraft and trade finance which the banks offers to customers. Whereas, the non-interest income is consisting of fees, commissions, brokerage charges and returns on investments in subsidiaries and securities. According to Vong et al (2009), the major source

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1

Appendix 1

Data from SPS 2011-2013 OJK

Ijarah, Istishna, Mudharabah, Musharakah, and Qard are in billion rupiah

ROA are in percetange

IJARAH ISTISHNA MUDHARABAH MURABAHAH MUSHARAKAH QARD ROA

2011M01 2436 351 8560 37855 14600 5922 2.26

2011M02 2417 360 8606 38983 14677 6407 1.81

2011M03 2572 328 8767 40877 14988 6721 1.97

2011M04 2630 315 8843 42453 15057 6427 1.9

2011M05 2730 317 9077 44118 15396 6980 1.84

2011M06 2927 322 9549 46161 16295 7362 1.84

2011M07 3076 319 9766 47453 16421 7521 1.86

2011M08 3208 319 9989 49455 17131 10437 1.81

2011M09 3209 335 10020 49883 17379 12013 1.8

2011M10 3336 329 10150 52148 17769 13073 1.75

2011M11 3561 325 10203 53993 18209 13135 1.78

2011M12 3839 326 10229 56365 18960 12937 1.79

2012M01 3872 307 10133 56473 18759 12145 1.36

2012M02 4337 312 10122 58326 19225 11390 1.79

2012M03 4193 312 10039 59165 19503 11026 1.83

2012M04 4897 285 10349 61895 20396 10945 1.79

2012M05 5044 320 10482 64544 21275 11179 1.99

2012M06 5219 322 10904 67752 22298 11097 2.05

2012M07 5469 345 11023 70730 22322 11021 2.05

2012M08 5733 354 11180 73826 23051 10803 2.04

2012M09 6054 361 11359 77153 24481 10949 2.07

2012M10 6434 355 11438 80953 25207 11195 2.11

2012M11 6912 366 11527 83826 26187 11499 2.09

2012M12 7345 376 12023 88004 27667 12090 2.14

2013M01 7520 382 12027 89665 28092 11986 2.52

2013M02 7808 414 12056 92792 28896 12107 2.29

2013M03 8363 424 12102 97415 30857 11919 2.39

2013M04 8619 479 12026 98368 32288 11626 2.29

2013M05 9501 496 12168 100184 33743 11168 2.07

2013M06 5550 487 12629 102588 35057 10917 2.1

2013M07 9546 508 13281 104718 35997 10436 2.02

2013M08 9856 539 13299 105061 35883 9900 2.01

2013M09 10197 530 13364 106779 36715 9735 2.04

2013M10 10244 528 13664 107484 37921 9442 1.94

2013M11 10462 551 13878 108128 38680 9133 1.96

Appendix 2

ROA IJARA ISTISNA MUDHARABAH MURABAHAH MUSHARAKAH QARD Mean 1.981944 5822.139 385.5833 11068.25 72948.28 24479.33 10323.28 Median 1.995000 5344.000 352.5000 10963.50 69241.00 22310.00 10985.00 Maximum 2.520000 10481.00 582.0000 13878.00 110565.0 39874.00 13135.00 Minimum 1.360000 2417.000 285.0000 8560.000 37855.00 14600.00 5922.000 Std. Dev. 0.213526 2723.026 86.18431 1549.601 24254.34 8118.676 2032.753 Skewness 0.014085 0.412802 0.960968 0.195802 0.153370 0.498098 -0.831609 Kurtosis 4.236269 1.794768 2.446428 2.035017 1.554355 1.863053 2.594218 Jarque-Bera 2.293733 3.201310 6.000422 1.626819 3.275970 3.427582 4.396429 Probability 0.317631 0.201764 0.049777 0.443344 0.194371 0.180181 0.111001 Sum 71.35000 209597.0 13881.00 398457.0 2626138. 881256.0 371638.0 Sum Sq. Dev. 1.595764 2.60E+08 259970.8 84044261 2.06E+10 2.31E+09 1.45E+08 Observations 36 36 36 36 36 36 36

Appendix 3

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.049224 Prob. F(2,27) 0.9521 Obs*R-squared 0.130786 Prob. Chi-Square(2) 0.9367 Test Equation:

Dependent Variable: RESID Method: Least Squares Date: 12/20/16 Time: 22:31 Sample: 2011M01 2013M12 Included observations: 36

Presample missing value lagged residuals set to zero.

Variable Coefficient Std. Error t-Statistic Prob. IJARAH -5.15E-07 4.10E-05 -0.012565 0.9901 ISTISHNA -0.000292 0.001779 -0.164409 0.8706 MUDHARABAH 3.28E-06 0.000110 0.029925 0.9763 MURABAHAH -1.62E-06 1.29E-05 -0.125765 0.9008 MUSHARAKAH 7.37E-06 5.56E-05 0.132605 0.8955 QARD -1.73E-06 2.07E-05 -0.083820 0.9338 C 0.035312 0.804961 0.043868 0.9653

RESID(-1) 0.063783 0.219506 0.290576 0.7736 RESID(-2) 0.034666 0.213845 0.162106 0.8724 R-squared 0.003633 Mean dependent var 7.72E-17 Adjusted R-squared -0.291587 S.D. dependent var 0.132648 S.E. of regression 0.150752 Akaike info criterion -0.734049 Sum squared resid 0.613603 Schwarz criterion -0.338169 Log likelihood 22.21287 Hannan-Quinn criter. -0.595876 F-statistic 0.012306 Durbin-Watson stat 1.796992 Prob(F-statistic) 1.000000

Appendix 4

Heteroskedasticity Test: White

F-statistic 0.317694 Prob. F(27,8) 0.9881 Obs*R-squared 18.62729 Prob. Chi-Square(27) 0.8832 Scaled explained SS 32.43724 Prob. Chi-Square(27) 0.2163 Test Equation:

Dependent Variable: RESID^2 Method: Least Squares Date: 12/20/16 Time: 22:35 Sample: 2011M01 2013M12 Included observations: 36

Variable Coefficient Std. Error t-Statistic Prob. C -1.222548 23.03761 -0.053067 0.9590 IJARAH^2 -2.57E-08 7.75E-08 -0.331977 0.7484 IJARAH*ISTISHNA 4.00E-06 1.06E-05 0.379251 0.7144 IJARAH*MUDHARABAH 6.72E-08 7.64E-07 0.087946 0.9321 IJARAH*MURABAHAH 3.15E-08 1.05E-07 0.300660 0.7713 IJARAH*MUSHARAKAH -1.28E-07 3.29E-07 -0.389132 0.7073 IJARAH*QARD -6.65E-08 2.29E-07 -0.289759 0.7794 IJARAH -0.000439 0.006979 -0.062869 0.9514 ISTISHNA^2 -2.18E-05 6.02E-05 -0.362084 0.7267 ISTISHNA*MUDHARABAH -2.10E-06 8.97E-06 -0.234218 0.8207 ISTISHNA*MURABAHAH -7.17E-08 6.84E-07 -0.104878 0.9191 ISTISHNA*MUSHARAKAH -9.44E-08 4.70E-06 -0.020106 0.9845 ISTISHNA*QARD -1.33E-06 2.20E-06 -0.605012 0.5619 ISTISHNA 0.035559 0.056668 0.627490 0.5478 MUDHARABAH^2 1.23E-07 5.77E-07 0.212303 0.8372 MUDHARABAH*MURABAHA

H 2.30E-09 4.54E-08 0.050779 0.9607 MUDHARABAH*MUSHARAK

AH -5.10E-08 4.27E-07 -0.119552 0.9078 MUDHARABAH*QARD -5.01E-08 1.14E-07 -0.440142 0.6715 MUDHARABAH -0.000663 0.007688 -0.086217 0.9334 MURABAHAH^2 1.85E-09 8.93E-09 0.207135 0.8411

MURABAHAH*MUSHARAKA

H -1.89E-08 3.90E-08 -0.484771 0.6408 MURABAHAH*QARD -8.50E-09 3.16E-08 -0.268965 0.7948 MURABAHAH 8.61E-05 0.000458 0.188043 0.8555 MUSHARAKAH^2 5.09E-08 1.18E-07 0.429931 0.6786 MUSHARAKAH*QARD 7.07E-08 9.38E-08 0.753867 0.4725 MUSHARAKAH -0.000453 0.003238 -0.140032 0.8921 QARD^2 1.58E-09 1.89E-08 0.083600 0.9354 QARD 0.000328 0.000899 0.365468 0.7242 R-squared 0.517425 Mean dependent var 0.017107 Adjusted R-squared -1.111267 S.D. dependent var 0.040193 S.E. of regression 0.058401 Akaike info criterion -2.791485 Sum squared resid 0.027286 Schwarz criterion -1.559859 Log likelihood 78.24674 Hannan-Quinn criter. -2.361615 F-statistic 0.317694 Durbin-Watson stat 2.719079 Prob(F-statistic) 0.988056

Appendix 5

Dependent Variable: ROA Method: Least Squares Date: 12/20/16 Time: 22:31 Sample: 2011M01 2013M12 Included observations: 36

Variable Coefficient Std. Error t-Statistic Prob. IJARAH -1.01E-05 3.95E-05 -0.256920 0.7991 ISTISHNA 0.001953 0.001456 1.340825 0.1904 MUDHARABAH -0.000115 0.000105 -1.100904 0.2800 MURABAHAH 5.29E-05 1.13E-05 4.679658 0.0001 MUSHARAKAH -0.000136 4.86E-05 -2.803890 0.0089 QARD -4.06E-05 1.92E-05 -2.118761 0.0428 C 2.458686 0.768958 3.197425 0.0033 R-squared 0.614078 Mean dependent var 1.981944 Adjusted R-squared 0.534232 S.D. dependent var 0.213526 S.E. of regression 0.145725 Akaike info criterion -0.841520 Sum squared resid 0.615841 Schwarz criterion -0.533614 Log likelihood 22.14736 Hannan-Quinn criter. -0.734052 F-statistic 7.690782 Durbin-Watson stat 1.703392 Prob(F-statistic) 0.000053