Influence of spin-off decision on financing risk: Empirical insight from Indonesian Islamic banks

Introduction

Islamic banking has emerged as a vital component of the global financial landscape, offering a unique alternative based on principles grounded in ethical and Shariah-compliant practices (Al Ansari & Alanzarouti, 2020; Jaafar & Brightman, 2022). Islamic banks dominate 70% of the total assets in the global Islamic finance sector, signifying a growth of 17% compared to the previous period. The primary driving force behind this accomplishment is the significant contribution of countries with Muslim-majority populations, particularly in the GCC, MENA, and Southeast Asia regions. This progress is primarily supported by effective governance and well-suited policies (ICD IsDB, 2022). In Indonesia, a prominent Muslim-majority nation, the Islamic banking sphere has showcased notable expansion and adaptability, establishing its role as a crucial element within the nation’s financial framework (Trinugroho et al., 2018). Within this period of growth, the spin-off policy has been contemplated as a strategy to navigate the complexities of contemporary banking while adhering Shariah principles (Pambuko & Sriyana, 2023; Trinugroho et al., 2021).

The phenomenon of spin-off becomes the one of the key dynamics influencing the financial performance of Indonesian Islamic banks (Pambuko & Sriyana, 2023; Trinugroho et al., 2021). As a strategy, this refers to the process of establishing separate entities from the parent institution, often with distinct business focuses (Chai et al., 2018). According to Article 68 of Law 21 of 2008, all Islamic windows are required to undergo a spin-off after 15 years or if their assets have exceeded 50% of their conventional parent bank’s assets (Nurkarim et al., 2021; Pambuko, 2019; Rokhmawati et al., 2022). The growing importance of this matter is underscored by the fact that the amendment of Law No. 21/2008 into Law No. 4/2023 retains spin-off as a key strategy for the acceleration of Islamic banking in Indonesia, albeit with the necessity of proper alignment. These spin-offs were achieved through various methods, including pure spin-offs, conversions, mergers, and acquisitions (Al Arif, Masruroh, et al., 2020a). The rationale behind such spin-offs often involves streamlining operations, improving risk management, optimizing organizational structures, enhancing efficiency, fostering growth, and complying with sharia law (Al Arif, 2014; Al Arif et al., 2018; Hamid, 2015).

The Financial Services Authority of Indonesia (2023) reports a significant increase in Islamic banking institutions as of May 2023. There are now 13 Islamic commercial banks and 20 Islamic windows, compared to just 5 commercial banks and 27 windows before the spin-off policy’s implementation. This law, enacted in 2008, mandated all Islamic windows to become full-fledged Islamic banks by 2023 (Pambuko et al., 2024). However, many Islamic windows haven’t completed this process, highlighting the need for further study on how spin-offs impact Islamic banking performance and their adherence to Sharia principles. Furthermore, the issue of spin-offs has also become one of the key strategies to enhance the contribution of Islamic banking in other countries. As reported, Pakistan, Bahrain, Kuwait, and Afghanistan are among the countries earnestly implementing this issue in the development of Islamic banks (ICD IsDB, 2022). Therefore, Indonesia, as a pioneer of the implementation of spin-off strategy in the Islamic banking sector, deserves to be a benchmark in the implementation of this strategy, particularly as an effort to sustain the Islamic banking industry.

In the last decade, many researchers have directed their attention toward identifying the impact of spin-off policies on the performance of Islamic banks. Several indicators of financial performance have been focused on, including profitability (Hamid, 2015; Nurkarim et al., 2021), efficiency (Al Arif et al., 2018; Al Arif, Mufraini, et al., 2020b; Al Arif & Nabilah, 2022; Hadziq et al., 2022; Pambuko, 2019; Rusydiana et al., 2019), market share (Al Arif, 2017; Al Arif et al., 2023), asset growth (Al Arif, 2015a; Al Arif et al., 2017), financing growth (Al Arif, 2015b), deposit growth (Al Arif, 2014, 2018b, 2018a; Al Arif et al., 2024), and market power (Rayyani et al., 2022). While there’s been a lot of research on spin-offs, how they affect a bank’s risk of financing risk (bad loans) has not been well-studied. This is an important gap to address, especially considering the recent Basel III framework from the Basel Committee on Banking Supervision (BCBS). These new global regulations aim to make banks worldwide more stable by considering all their risks, both from loans they’ve made (on-balance sheet) and from their commitments (off-balance sheet exposures) (Abdurraheem et al., 2023).

This scientific paper aims to bridge these knowledge gaps by offering an empirical analysis of the relationship between spin-off decision and the prevalence of financing risk in the Indonesian Islamic banking sector. While previous research suggests spin-off decisions can improve financial performance, the potential effect on financing risk has been overlooked. This study will address this gap by examining how spin-offs influence financing risk. This is crucial given the pivotal role of financing risk management in impacting profitability, financing capacity, and overall financial stability (Pratami et al., 2023; Sriyana, 2015), where spin-offs hold the potential to mitigate such risks. By untangling these linked factors, we aim to provide valuable insights for both academics and Islamic bankers, fostering a deeper understanding of how strategic restructuring impacts the financial soundness of Islamic banks. Moreover, given the intricate relationships between spin-off strategies and financing risk, policy implications and strategic recommendations stemming from this study could serve as a catalyst for informed decision-making within the Islamic banking industry.

Literature review

The management of bad financing or non-performing financing (NPF) presents a critical challenge for Islamic banking institutions in Indonesia (Imaduddin, 2008; Nugroho et al., 2018; Soekapdjo et al., 2018). Non-performing financing, characterized by loans or financing contracts in default or at risk of default, can have far-reaching implications on the stability and credibility of financial institutions (Hernawati et al., 2021). In traditional banking, its known as non-performing loan (NPL). The existence of financing risk can hinder the stability of Islamic banking entities, potentially jeopardizing their capacity to facilitate economic growth and foster financial inclusivity (Banna et al., 2022). Considering the distinct characteristics of Islamic finance, rooted in risk-sharing and asset-backed principles, a comprehensive exploration of how spin-off decisions influence financing risk, specifically non-performing financing, requires further investigation.

Conceptual framework

Although numerous factors have been identified as influencing financing risk, the findings across studies tend to show inconsistencies. These discrepancies may be attributed to differences in research settings, observation periods, and data analysis techniques. Nevertheless, this study focuses on presenting findings that are theoretically grounded and relevant to the existing literature.

In line with this, the main objective of this research is to examine the impact of the spin-off decision on financing risk in Islamic banking in Indonesia—an aspect that has not been previously explored. The study also incorporates control variables, including internal bank conditions (bank size and market share) and macroeconomic indicators (inflation, economic growth, and oil price). The conceptual framework is illustrated in Figure 1, and the hypotheses are formulated as follows:

H1:

The spin-off decision has a negative effect on financing risk

H2:

Bank size has a positive effect on financing risk

H3:

Market share has a positive effect on financing risk

H4:

Inflation has a positive effect on financing risk

H5:

Economic growth has a negative effect on financing risk

H6:

Oil price has a negative effect on financing risk

Figure 1. Conceptual framework.

Methods

To examine the impact of spin-off decisions on financing risk, this study utilizes semi-annual bank-level data from 2006 to 2022 for Islamic banks in Indonesia. The bank-specific data, derived from the financial statements of 35 Islamic banks, were acquired from the Islamic Banking Statistics which is reported by Indonesian Financial Services Authority (FSA). The sample consists of 16 full-fledged Islamic banks and 19 Islamic windows. Macroeconomic data were sourced from Statistics Indonesia, Bank Indonesia, and OPEC basket price. We employed an unbalanced panel dataset encompassing 1032 observations.

The Indonesian Islamic banking landscape has witnessed various restructuring strategies. Pure spin-offs were employed by banks such as Bukopin Syariah and BNI Syariah in 2008, BRI Syariah in 2010, BJB Syariah in 2010, and Bank Nano Syariah in 2024. Conversion, another common approach, was adopted by BTPN Syariah in 2014, Bank Aceh Syariah in 2016, BPD NTB Syariah in 2018, and BPD Riau Kepri Syariah in 2022. The formation of Bank Syariah Indonesia in 2021 marked a significant merger in the sector. Moreover, a combination of acquisition and conversion was utilized sequentially by banks including Bank Panin Dubai Syariah in 2009, Bank Victoria Syariah, BCA Syariah, and Bank Aladin Syariah in 2010.

Table 1 explains the data we used in this study. We looked at the ratio of non-performing financing (NPF) to total financing, which is a common measure of bad loans in Islamic banks (Saw et al., 2022). Spin-off is a proxy for spin-off decisions, represented by a dummy variable where 1 denotes post-spin-off time and 0 signifies pre-spin-off time. The bank-specific factors include bank size (log total assets of each Islamic bank) and market share, assessed by the individual Islamic bank’s asset over the total asset industry of Islamic banks. To understand the economic climate, we looked at the Consumer Price Index (CPI) for inflation and the Industrial Production Index (IPI) for economic growth. The variable OIL is based on the OPEC basket price, which represents the per-barrel oil price. This price serves as a crucial benchmark in determining crude oil prices in the global market, including Indonesia, although it is merely one of many indicators influenced by various complex factors.

This study utilizes a dynamic panel regression model with individual fixed effects to assess the impact of spin-off decisions on financing risk for Islamic banks in Indonesia. The dynamic panel approach addresses both unobserved bank-specific characteristics and potential endogeneity issues that might bias the results. To further account for potential simultaneity and correlation between variables, the study employs the Generalized Methods of Moment (GMM) estimation technique. This approach was adopted to mitigate several underlying problems commonly encountered in panel data, specifically endogeneity, heteroskedasticity, and autocorrelation. Equation (1) details the empirical model used in this analysis, which incorporates the spin-off decision as the main independent variable. Additionally, control variables such as bank size, market share, and macroeconomic factors like inflation, economic growth, and oil price are included to account for their potential influence on financing risk.

Where Y_it is the non performing financing (NPF) for bank i and year t; Spinoff_t is a dummy variable, it is one if the period after spin-off decision, zero otherwise; BankSpecific_i,t is control variable consisting of bank size dan market share; MacroEconomic_t is control variable consisting of inflation, economic growth, and oil price; and ε_i,t is the error term. The first lag of the dependent variable has been integrated into the model as an independent variable to address the possible persistence of NPF changes in time. Our analyses utilized a difference GMM Arellano-Bond estimator. To ensure robustness, we conducted a two-step System GMM estimator for further validation.

Then we analyze the impact of bank size on the interaction between spin-off decisions and non-performing financing. We created an interaction variable in the form of Spinoff_t*Size_it for this purpose. The Equation (2) represents the estimation model.

Data analysis was conducted using EViews 12 by S&P Global. Prior to interpretation, diagnostic tests were performed. The Sargan test was employed to assess the validity of the instruments, while the Arellano-Bond test was used to detect the presence of autocorrelation. A lag order of one (lag 1) was used for estimation. A well-specified model should exhibit valid instruments and no autocorrelation.

Results and Discussion

Conclusion

This study investigates the impact of spin-off decision – the separation of Islamic windows from their conventional parent banks to become full-fledged Islamic banks – on financing risk in Indonesian Islamic banks. We estimate over a substantial timeframe in the journey of Islamic banks in Indonesia, spanning from 2006 to 2022. Empirically, our findings reveal that Islamic windows carry a higher risk compared to full-fledged Islamic banks that undergo spin-offs. We also discover that spin-off Islamic banks with larger assets are more exposed to risk than those with smaller assets. This notice is supported by the regression that financing risk increases with the growth of assets and market share. Theoretically, this research contributes to the broader understanding of Islamic banking dynamics by providing empirical evidence on the risk implications of organizational structure transformation. Specifically, it highlights the potential risk reduction associated with the increased autonomy and focused operational framework of independent Islamic banks post-spin-off.

These findings yield several policy implications. We have strong evidence that the independence of Islamic banks makes them more sensitive to risk and adept at mitigating it. Consequently, the implementation of a spin-off policy represents a viable approach. This is further supported by the amendment of Law No. 21/2008 to Law No. 4/2023, which continues to accommodate spin-offs as a policy to foster the growth and contribution of Islamic banking to the national economy. Moreover, the potential rise in market dominance by Islamic banks, which could amplify financing risk, calls for complementary policies to mitigate the potential negative outcomes.

The present study has identified several limitations. The utilization of a dummy variable to assess the impact of spin-offs on financing risk, while effective in capturing the immediate effects of regulatory policies, may not fully account for the nuanced dynamics at play. Moreover, the study’s scope is constrained by the use of semi-annual data up to 2022 and its focus on the Indonesian Islamic banking industry. To address these limitations, future research could benefit from employing a difference-in-differences analysis to more precisely estimate the causal impact of spin-offs. Furthermore, incorporating a broader range of internal and external variables, as well as expanding the analysis to include Islamic banks in Southeast Asia or OIC countries, would provide a more comprehensive understanding of the phenomenon.