International Journal of Finance,

Economics and Business

Vol. 1, No. 2, June 2022, pp.118-131. e-ISSN:2948-3883
© 2022 SRN Intellectual Resources [Link]

Article

Investigating the Performance of the Islamic Banking

System and Social Welfare
Yao Ming Lee 1,*, Hazman Samsudin 1 and Jumadil Saputra 1

1
Department of Economics, Faculty of Business, Economics and Social Development, Universiti Malaysia
Terengganu, 21030 Kuala Nerus, Terengganu, Malaysia; hazman.s@[Link] (H.S.);
[Link]@[Link] (J.S.)
* Correspondence: p4962@[Link]

Citation: Lee, Y.M., Samsudin, H. & Saputra, J. (2022). Investigating the Performance of Islamic Banking System
and Social Welfare. International Journal of Finance, Economics and Business, 1(2), 118-131.
[Link]
Academic Editor: Yunieta Anny Nainggolan.

Received: 10 March 2022 Accepted: 3 June 2022 Published: 30 June 2022

Abstract: This study was conducted to investigate further how Islamic Banking Performance may improve
social welfare in Malaysia since the bank put one of its objectives to improve livelihood through its Shariah
non-compliance fund. Reports highlighted that exceeding Shariah's non-compliance risk will cause force
majeure to the bank and even the risk of bankruptcy. This study aims to discuss and clarify the risk of
non-compliance with Sharia Law in the Islamic financial system. The data for this research is based on
annual financial reports ranging from the year 2014 until 2019, consisting of 8 Islamic Financial Institutions
(IFIs) in Malaysia, namely; Affin Bank, Alliance Bank, Ambank, Bank Islam, Hong Leong Bank, Maybank,
OCBC Al-Amin bank and Public bank. Three-stage least square method incorporates the mediator variable
in the simultaneous equation model. The result of this study pointed out that both variables significantly
impact each of them. In short, the Shariah non-compliance funds can indeed affect the main factor of bank
failure, capital adequacy ratio, but it has a positive effect on social welfare through GDP at the same time.
Therefore, to balance the relationship between the two points, the government must formulate effective
maintenance methods for Islamic Financial Institutions (IFIs) in Malaysia. Under the premise of improving
social welfare, the IFIs can also safely maintain and operate.

Keywords: Islamic financial institutions; shariah non-compliance risk; capital adequacy ratio; social
welfare; three stages least square

Copyright: © 2022 by the authors. Submitted for possible open access publication under the terms and conditions
of the Creative Commons Attribution (CC BY) license ([Link]

1. Introduction
Finance is the core of the modern economy. Under the trend of economic globalization, the global
financial industry is also showing a more open and diverse pattern. Currently, the Islamic financial industry
shows strong vitality, and It is very active in the global economy. Apart from Islamic countries, many
non-Islamic countries are joining the ranks of Islamic finance (Banking system). According to Karasik et al.
(2006), nearly 80 countries (including non-Islamic countries) have started operating Islamic banks and

International Journal of Finance, Economics and Business

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related businesses globally. Besides the unique meaning due to the limited influence of Islamic law, Islamic
Banking also has the general characteristics of the commodity market financial system.
So, what’s the difference between conventional banking and Islamic banking? The economic life of
Muslims is rooted in the decision of the holy religion. Ariff & Lewis (2014) highlighted the basic operation
of Islamic Financial Institutions is based on profit and loss sharing. Besides, Islamic banks cannot charge
interest on giving the loan or receiving the deposit. According to Usmani (2021), the word "interest" is
derived from the Arabic word "Riba". The broad interpretation of "riba" in the Hadith is any profit or
income earned without work, such as profit from chance and certain barter exchanges of varying quantities
or delayed delivery by one party is considered to have interest, should be among the prohibited. We all know
that banks can’t escape interest, which is why Islamic Banks classify profits from interest as Shariah
Non-Compliance Income (SNCI). The amount of SNCI will give back to society to offset the sin of
receiving interest. However, Bälz & Cambridge (2008) pointed out that Shariah Non-Compliance Income
(SNCI) is challenged because it does not abide by Islamic law.
Then, Hamid & Ginena (2015) said that Islamic financial banks might suffer financial losses due to
non-compliance activities determined by the Sharia Supervision Committee. On the other hand, the
profit-and-loss sharing concept (Mudarabah) of Islamic Bank alleviates certain risks for banks, but it also
exposes banks to face the new risks. For avoiding the interest (riba), the income from the interest must be
donated to charity or given back to the societies. This option will decrease a bank's profits and indirectly
increase the bank's operating costs. Due to this reason, International Omar & Hassan (2019) stated that if the
SNCR increases significantly, it may expose banks to reputation and bankruptcy risks. SNCR may
significantly impact banks’ Capital Adequacy Ratio (CAR). Further consideration, CAR might be affected
social welfare through Gross Domestic Product (GDP) per capita.
In this case, Shingjergji & Hyseni (2015) selected five banks' annual financial data from 1999 to 2006,
the annual real GDP growth rate and the bank’s non-performing loan rate as the variables to define the
relationship between them. Undeniable, her empirical results are consistent with a significant relationship
between both. In addition, Ebenezer et al. (2018) selected 16 commercial banks from 2009 to 2015 to study
the relationship between the variables. Again, his analysis shows that operational risk and GDP play an
important role in the performance of commercial banks during the study period. Considering their
relationship, does it indirectly clarify that GDP is significantly affected by Banks’ CAR? Does Islamic
Banking affect social welfare? This kind of curiosity drove the research motivation.
Malaysia is in the row of Muslim countries that are not only developing an Islamic Banking system but
also a complete Islamic Financial system. Islamic Finance (Islamic Banking system) started in Malaysia in
1983, Bank Islam Malaysia Berhad (BIMB). Islamic finance generally refers to financial entities established
and operated following the framework of Sharia. The core of the Islamic financial system is to prohibit the
collection and payment of interest. It advocates risk sharing, personal rights and responsibilities, property
rights, and the sanctity of contracts. It emphasizes that funds must involve actual economic production
activities and emphasizes the fair distribution of wealth. And the invested enterprises must also confirm the
principles of social ethics. The core of Islamic finance is an Islamic bank with no interest. Modern Islamic
financial forms are inextricably linked to religions. For example, any new Islamic financial products must be
approved by Islamic jurists before they can be issued.
Another example is the financial supervision system of the Islamic world in countries and countries.
There will be organizations similar to religious advisory committees at both levels of the company to define
the relevant business of Islamic financial institutions to ensure that their business and operations comply
with the requirements of Shariah law. God allows finding a legitimate transactions and commodity trading.
However, Islamic law strictly prohibits any transaction involving injustice, fraud or exploitation, thus
forming an Islamic financial philosophy that allows for loans but strongly condemns the high-profit
exploitation financial philosophy. Under this philosophical guide, a large Islamic financial system was
formed and shaped.
Unfortunately, not many studies have been done on the variables (related to Shariah Non-compliance
Risk, Capital Adequacy Ratio and social welfare), and it is very lack of study in this area. Most researchers
have focused on distinguishing between Islamic and conventional banks or the potential between them.
Because of the shortage of research, we decided to use past research as references to study new topics.
Moreover, Islamic Banking will indirectly improve social welfare. Social welfare refers to the social
insurance system in which the state guarantees a certain standard of living to provide all citizens with funds
and services that can improve their quality of life as much as possible. Due to the disparity between the rich
and the poor being quite big in Malaysia and leading to data deviation, thus, Islamic Banking is chosen to be
the topic. In addition, this issue is more relevant to the Islamic Financial Institutions because they clearly
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state that it is committed to improving social welfare through certain provisions, such as Shariah
Non-compliance funds. The source of this fund is the bank's income through interest. The purpose is to
avoid violating Sharia law compliance (interest is prohibited). However, the research on this path and
matters is very limited and getting more effective information in Malaysia isn't easy.
After investigation, most past studies used a standard single linear model equation to test the model
and regarded the variables as having a direct relationship. However, these studies believe that the impact of
welfare is indirect rather than direct. Therefore, a single linear equation measurement model cannot meet the
requirements of this research. Generally, the bank's main goal is still the entity that maximizes profits, and
the impact of welfare may only appear indirectly after the accumulation of profits. As a result, non-Islamic
law-compliant funds rely on the accumulation of profits, which has an indirect impact. This study will use
3SLS as the specification model to measure the three layers of effect brought by Islamic Banking. Only in
this way we can accurately measure the indirect impact brought by a single variable. This study is to identify
the relationship between SNCR, CAR and social welfare. Then, this study seeks to relate the impact of
Shariah non-compliance funds and bank profits toward social welfare in Malaysia. In addition, investigate
the simultaneous equation model to consider the indirect impact on social welfare.

2. Literature Review
This section will discuss in more detail and depth the Shariah Non-compliance Risk (SNCR) and
independent variables that had been reviewed in the previous section. Besides, it will review more on 1) to
determine the impact of Inflation Rate (INFLAT), Return on Assets (ROA), Return on Equity (ROE),
Liquid ratio (LIQ) on Islamic Banks’ Capital Adequacy Ratio (CAR), 2) to determine the impact of Islamic
Banks’ Capital Adequacy Ratio (CAR) and Unemployment Rate (UE) on Shariah Non-compliance Risk
(SNCR), 3) to determine the Shariah Non-compliance Risk (SNCR) on social welfare. This section can help
build up the concept or model from the theories and methods. In addition, research conducted for the
previous review can assist in determining the variables used in this study. It can help avoid this problem
and be more effective in the next few sections. In general, some facts deviate from theory, and the
identification of the difference between theory and fact can be drawn from the literature through empirical
research and comparison. Therefore, there is always room for improvement through literature review to
make the research more comprehensive.
According to Sairally (2013), discussions on the development of the act of Islamic Finance featured the
benefit, and financial productivity thought processes of Islamic Financial Services as opposed to their
anxiety for socio‐economic value and government assistance recently. A uniqueness between the financial
aspects of writing on Islamic Finance and the course taken by the practical field of Islamic banking and
finance has emerged throughout the long term. Thus, she conducted a study to discuss the assessment.
Salma’s study showed that the discoveries uncovered that most the Islamic Financial experts had faith in
crediting a coordinated social job to Islamic Financial Services. In any case, the acts of the Islamic Financial
Services mirrored a more restricted way of dealing with corporate social responsibility. Most of the Islamic
Financial Services were the important issue around meeting their legitimate, monetary and Shariah
obligations. It worried about the objectives of benefit boost, and for their exchanges to meet Shariah's
consistency, corporate social responsibility was drilled as a fringe movement by the Islamic Financial
Services rather than being indispensable, well-thought-out and purposeful strategy choice of the board.
Many Islamic financial institutions have subtly changed and gradually developed to focus on interests. It is
also an indirect overturn of the purpose of Islamic laws.
Moreover, Mohieldin (2012) also recognized the development potential of Islamic financial
institutions. Global Shariah-compliance financial assets have expanded in recent years, reaching about
US$1 trillion in 2010, up from about US$5 billion in the last part of the 1980s. In 2011, the total volume of
Sukuk issuances rose to about US$50 billion. Although the Sukuk market is little contrasted to conventional
with regular fixed-pay or securitized items, the more fragile exhibition of traditional instruments during the
emergency is consolidating with a more noteworthy acknowledgement by backers that Sukuk is a viable
choice to support market craving.
In addition, the research study by Boukhatem & Moussa (2018) conducted a test to set up a theoretical
framework for the relationship between Islamic Financial Institutions' performance and economic growth
for 13 countries in the MENA region from the period 2000 to 2014. They proved the statement with strong
evidence that the development of IFIs stimulated economic growth. The discoveries recommend that
legislatures consider carrying out proactive and great monetary and institutional strategies for Islamic
Finance. These previous studies stated clearly the potential of Islamic finance. In order to further the studies,
this study will use conventional bank investigation factors to measure the growth of Islamic finance.
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Based on previous studies, Capital Adequacy Ratio (CAR) is the main factor affecting financial
institutions' performance. However, it can be concluded that there are only a few numbers of past research
on the performance of the Islamic banking system and social welfare, linking the relationship between
Shariah Non-compliance Risk (SNCR) and Capital Adequacy Ratio (CAR) and social welfare. One of the
basic requirements of banks and financial institutions is adequate capital. Therefore, every bank and
financial organization must maintain a balance between the available risks in capital and assets. For
conducting the studies, some specific variables are decided for the add-on, for instance, Inflation Rate
(INFLAT), Return on Assets (ROA), Return on Equity (ROE) and so on.

2.1 Impact of Inflation Rate (INFLAT), Return On Assets (ROA), Return On Equity (ROE),
Liquid Ratio (LIQ) on Islamic Banks’ Capital Adequacy Ratio (CAR)
The capital adequacy ratio is crucial in deciding the degree of hazard assimilation of a financial
foundation. This issue has been talked about generally as it is a significant measuring stick to check the total
image of banking execution. Capital ampleness is firmly identified with the monetary presentation of related
countries. As pointed out from the past research, the Inflation rate (INFLAT) has a statistically significant
impact on CAR. For proving this statement, Yahaya et al. (2016) organized research to identify the impact
of CAR on the financial performance and economics of Japanese regional banks. The study used five
variables representing economic performance: unemployment rate, inflation rate, real exchange rate, money
supply, and gross domestic product. The study consisted of 10 years of data from 2005 to 2014, and 64
regional banks were evaluated. The research results show that the INFLAT has a certain degree of influence
on the bank CAR. It is the same results get from Thi Hien’s studies.
Nguyen (2020) determine the effect of the CAR on bank interest under the Basel II implementation
basis in Vietnam. In this investigation, bank productivity is estimated by resource return and value return.
Regardless of the share of capital strength, he also controls different determinants of profit potential,
including the bank’s explicit factors (proportion of capital adequacy, net income advantage, unpaid
advances, non-premium salaries, ownership, and administrative factors addressed by the bank’s use of
Basel. Standards), and macroeconomic indicators (rate of GDP expansion, rate of expansion). Thi Hien’s
paper investigates the return of information on an example of 22 Vietnamese banks from 2010 to 2018. The
results proved that inflation significantly and positively related to Vietnamese bank profitability in CAR.
Since a higher inflation rate builds the vulnerability on the lookout, leading banks to have higher capital
measures. Another outcome is a positive connection between the capital adequacy ratio and the inflation
rate. Yahaya et al. (2016) also underlined this situation in the literature. On the other hand, Bokhari et al.
(2012) showed no relationship between capital adequacy ratio with economic growth and inflation rate.
Apart from using INFLAT, return on assets (ROA) and return on equity (ROE) will also be chosen as
the variables to identify CAR clearly. ROA and ROE have a very strong correlation with the banks’ CAR. It
is because the statement of (Bateni et al., 2014)proved a positive correlation between loan assets ratio
(LAR), ROE, ROA and CAR. They are focusing on the financial factors of Iran's private bank from 2006 to
2012. In addition, from studying the determinants of CAR in the banking system of Saudi Arabia, ROA was
positively significant with CAR Polat & Al-khalaf (2014). Numbers of past studies have proved and shown
the significant relationship between CAR, ROA and ROE. However, the past studies by Shingjergji &
Hyseni (2015) stated explicitly that there is a lack of relationship between ROA, ROE and CAR. The
variables are not correlated at all. Due to the distinct differences, ROA and ROE were selected to define
their relationship with CAR, and the disagreement can be rejected or accepted.
There is no denying that the Islamic Financial System has its fascinating features. Some researchers
directly study CAR's determinants in the Islamic banking system. Abusharba et al. (2013) examined the
banks’ CAR in Indonesia using several variables. Then the results showed that ROA and Liquidity (LIQ)
were positively related to CAR. As stated, liquidity can also be considered a manipulative variable in the
study. In order to verify this variable, similar studies are used to clarify it.
Osama & Saleh (2018) investigate the determinants of CAR on commercial banks in Egypt. For
example, asset quality, bank size, liquidity, profitability, and risk and management quality. The liquidity
represented only in loans to deposits significantly correlates positively to the capital adequacy ratio. Asset
quality is significantly correlated positively to the capital adequacy ratio. Also, earning assets to total assets
appears to impact the capital adequacy ratio. Moreover, in India, Abusharba et al. (2013) reported that CAR
is negatively related to loan assets ratio LAR, assets quality and management efficiency, but the liquidity
was positively related to CAR.
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2.2 Impact of Capital adequacy ratio (CAR) and Unemployment rate (UM) on Shariah
non-compliance risk (SNCR) and Social welfare
To manage the operational risk and evaluate the banks’ CAR, they develop a framework for it
Abusharba et al. (2013). While Herring (2002) argue that insurance is part of the entire risk management
process, the capital adequacy ratios focus should be on the residual risk after insurance. To reiterate, there
is a difference in the measurement of risk between conventional banking and Islamic banking. Conventional
banking uses the gross income to measure operational risk; Islamic banking uses Shariah Non-compliance
income (SNCI) to measure SNCR. Simply put, the two different types of risks are the same indicator.
According to Odunga et al. (2013), the studies show that the operating efficiency and risk-based
capital ratio of the previous year have had a positive and significant impact on the bank’s operating
efficiency. The amount of R2 obtained from the returned income is 0.4135, which means that 41.35% of
the bank’s operational efficiency results from credit risk and capital adequacy measures. The company's
performance history will affect how it streamlines its operating strategy. Banks should look for
mechanisms to increase risk-based capital ratios to improve operational efficiency and maintain market
competitiveness. It shows that CAR has an inseparable relationship with SNCR.
Li et al. (2009) selected the net profit of five banks' annual financial data from 1999 to 2006, the annual
real GDP growth rate, bank total capital adequacy and the bank’s non-performing loan rate as the variables
to define the relationship between them, and used EVIEWS to perform regression analysis. Their empirical
results are consistent with this value, and they have a significant relationship. While Ebenezer et al. (2018)
identified that existing studies are sketchy in developing economies while most studies are largely
theoretical and have lesser empirical evidence. Data on audited financial reports selected by 16 commercial
banks for 2009 to 2015 have been collected, making up to 112 observations. In the results, the firm
performance is measured by net interest margin while the operational risk is proxy by cost to income and
total operating expenses to total assets ratio. The controlled variables used in this study include bank size
and GDP growth rate. Based on the random effect analysis in the model as compared to operational risk,
GDP play an important role in the performance of commercial banks during the period of study. This clarify
that GDP are significantly affected by Banks’ CAR. There is strong relationship between these two
variables.
To investigate the relationship between GDP per capita and social welfare, Van den Bergh & Antal
(2014) stated that GDP per capita is an informative indicator of social welfare across various countries.
Therefore, how much the social welfare can identify by measuring GDP. Besides, based on Hanif et al.
(2019) analysis conducted using the stepwise, the result shows that the macroeconomic unemployment rate
is the main factor affecting and influencing the bank's operation. Then, the unemployment rate can influence
bank steadiness (expanding operational risk). The increasing unemployment rate may prompt a generous
decrease in the interest for new advances, prompting a huge decay in the proportion of revenue procuring
resources for premium acquiring liabilities. Cristea et al. (2014). In addition, Badalashvili (2017)
highlighted that unemployment seems to have a strong impact on the capital adequacy ratio of Greek banks.
Although this paper is focused on the Greek economy, it may help identify the correlates of bank capital
ratios in Malaysia.

2.3 Research Framework

This section is to generate a theoretical framework to capture the relationship between Shariah's
Non-compliance risk, capital adequacy ratio and social welfare. The theoretical framework is a structure
that supports a research study's theory and makes it easier to explain the relationship between variables.
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Figure 1. Relationship between Shariah non-compliance risk, capital adequacy ratio and social welfare.

Figure 1 shows the relationship between Shariah's non-compliance risk, capital adequacy ratio and
social welfare. Based on Figure 1, Shariah non-compliance risk is one of the variables affecting social
welfare (estimate through GDP). This variable is expected to have a positive relationship with social
welfare, which means an increase in SNCR will also increase social welfare. The previous studies proved
that social welfare in a country could display by estimating the Gross Domestic Product. The next variable
that affects the SNCR is the capital adequacy ratio and unemployment rate. The two variables are expected
to have a positive relationship with SNCR. As the previous section shows a strong relationship between both
variables (either positive or negative), we can also establish the model. The last model that selected variable
as capital adequacy ratio can be affected by numbers of variables, which are inflation rate, return on assets,
return on equity and the liquidity of a bank.
The relationship between SNCR, CAR and social welfare has not yet been clarified. We bridge this gap
in two important directions. First, we use our model to show how one unified theoretical framework is
broadly consistent with the observed dynamics of both economic growth as well as the Shariah
Non-compliance Risk and Bank’s Capital Adequacy Ratio. Secondly, we estimate our model using the
method by the inflation rate, unemployment rate and GDP in Malaysia for 6 years, from 2014 to 2019. It
allows us to show how its predicted adoption patterns match the patterns observed in the data. Most previous
studies have focused on the benefits of Islamic finance and laws or contrasted them with the conventional
banking system. Little is known about whether Islamic finance will lead to bankruptcy due to Shariah
Non-compliance funds and whether it can improve the social welfare of our country. Therefore, this
research will refer to the results of the previous research and use the measurement of the relationship
between Shariah Non-compliance funds and social welfare as a starting point. This research aims to analyse
the development of Islamic financial institutions in Malaysia and determine the short-term and long-term
relationship between their SNCR, the country’s economy and social welfare.

3. Materials and Methods

Data collection of this research is based on secondary data from 2014 to 2019. A total of eight Islamic
Banks in Malaysia will be used as the study target of this research: Affin Islamic Bank Berhad, Alliance
Islamic Bank Berhad, Ambank Islamic Bank Berhad, Bank Islam Berhad, Hong Leong Islamic Bank
Berhad, Maybank Islamic Berhad, OCBC Al-Amin Bank Berhad and Public Islamic Bank Berhad. The
variables used are Inflation rate (INFLAT), Return on Assets (ROA), Return on Equity (ROE), Liquid ratio
(LIQ), Capital Adequacy Ratio (CAR), Unemployment Rate (UM), Shariah Non-compliance Risk (SNCR),
Gross Domestic Product (GDP) and social welfare.
As stated, we will choose Three-stage Least Square (3SLS) as my method to measure the variables
simultaneously at a time. According to Zellner and Theil (1962), the 3SLS is a method that goes one step
further than using the Two-stage Least Square (2SLS). 2SLS is a method of calculating structural
equations involving two steps. The first step is to calculate the simplified form of the interference moment
matrix, and the second step is to estimate the combination coefficients of the moment matrix structure.
While 3SLS method further uses the 2SLS estimated moment matrix of the structural disturbances to
simultaneously estimate all coefficients of the entire system.
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3.1 Source of Data

Data collection of this research is based on secondary data from 2014 to 2019 in Malaysia. Then, the
data was collected from both banks’ annual financial statement reports. Data exported from the annual
report are individuals using the internet, which is presented in value of basic information.

3.2 Definition of Operational Variables

3.2.1 Shariah Non-Compliance Risk (SNCR)
According to Basiruddin & Ahmed (2019), Shariah Non-Compliance Income (SNCI) represents
Shariah Non-Compliance Risk (SNCR) since the revenue from these activities is excluded from the bank’s
income and is given to charity. Since the costs are incurred but no revenue is generated, the net losses on
these bank transactions. Shariah non-compliance risk (SNCR) refers to the risk caused by the Islamic
Bank’s failure to comply with the Shariah rules and principles established by Shariah consultants or
related institutions in the jurisdiction where Sharia Bank operates. Islamic banks must ensure that their
contract documents comply with the rules and principles of Sharia in terms of preparation, termination
and elements that may affect the execution of the contract. Non-compliance with Shariah law can lead to
failure to recognize income and losses (IFSB, 2005a). In addition, most fund providers use Islamic
banking services in principle, so their perception of Islamic banks’ compliance with Islamic rules and
principles may be important to maintaining customer loyalty.

3.2.2 Capital adequacy ratio (CAR)

The capital adequacy ratio (CAR) measures the bank’s available capital and the percentage of the
bank’s risk assessment. The capital adequacy ratio, also known as the capital risk-weighted asset ratio
(CRAR), is used to protect those depositors and promote the stability and efficiency of the global financial
system. In addition, the capital adequacy ratio (CAR) can ensure that the bank has enough buffer and
resistance before bankruptcy. Regulators will determine the bank’s management risk based on the bank’s
capital adequacy ratio (CAR). The capital ratio shall not be less than 8%. The capital adequacy ratio (CAR)
stipulated in Pillar 1 of Basel II is as follows:
Tier 1 + Tier 2
CAR = (1)
Risk − Weighted Assets
3.2.3 Unemployment rate (UM)
The unemployment rate is characterized as jobless workers in the complete workforce. Labourers are
viewed as jobless if they right now don't work, notwithstanding the way that they are capable and able to do
as such. The unemployment rate gives experiences into the economy's extra limits and unused resources.
According to Noor et al. (2007), the average percentage of unemployment rate at 3.1% in 2000.

3.2.4 Inflation rate (INFLAT)

The inflation rate is the rate increment or diminishing costs during a predetermined period, normally a
month or a year. The rate discloses to you how rapidly costs rose during the period. Statistics Malaysia
released December inflation data on 22 January 2021. In December, the Consumer Price Index (CPI) fell
1.4% year on year and recorded negative year-on-year growth for 10 consecutive months. Inflation for the
whole year of 2020 is -1.2%, the first annual deflation since 1969. Looking forward to 2021, Malaysia's
inflation level is expected to return to positive growth due to the low base effect and the accelerated recovery
of economic activities. However, the government's re-implemented Movement Control Order (MCO 2.0) in
mid-January this year will bring downside risks to the inflation data in the first quarter. The development of
the epidemic and the vaccination progress will also bring certain uncertainty to the inflation level in the
second half of the year.

3.2.5 return on assets (ROA)

Return on Assets (ROA) is also net profit after tax/total assets. It is used to measure how much net
profit is created per unit of an asset—a useful indicator for evaluating a company's profitability relative to its
total asset value. The calculation method is the company's annual profit divided by the total asset value, and
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the return on assets is generally expressed as a percentage. Sometimes called return on investment. The
calculation of return on assets (ROA) is as follows:
Net Income
ROA = (2)
Total Assets
3.2.6 Return on equity (ROE)
Return on equity (ROE) is determined by separating the organization's net gain by investors' value to
quantify the organization's effectiveness in creating benefits. Numerous components might influence ROE.
For instance, an organization has persevered through numerous ominous factors or started a stock
repurchase plan. Another impediment of utilizing ROE to assess stocks is that it avoids the organization's
elusive resources, for example, protected innovation rights and brand mindfulness from the computation.
Even though ROE can assist financial backers with distinguishing productive stocks, it likewise has its
deficiencies and isn't the lone marker that financial backers should examine when assessing stocks. The
calculation of ROE is as follows:
Net Income
ROE = (3)
Shareholder ′ s Equity

3.2.7 Liquidity ratio of the bank (LIQ)

The liquidity ratio of the Bank (LIQ) is also named current assets. It refers to the assets that an
enterprise can realize or use in a business cycle of one year or more than one year and are an essential part of
enterprise assets. In the transition of liquidity, starting from the currency form, changing its form in turn, and
finally returning to the currency form, various forms of funds and production. The circulation is closely
integrated, the turnover speed is fast, and the realization ability is strong. Strengthening the audit of the
current asset business is conducive to determining the legality and compliance of the current asset business,
checking the correctness of the accounting treatment of the current asset business, exposing its drawbacks,
and improving the use of current assets. The calculation of the liquidity ratio of the bank (LIQ) is as
follows:
Liquid Assets (Quick Assets)
LIQ = (4)
Current Liabilities
3.2.8 Gross domestic product (GDP)
Gross domestic product is a proportion of the all-outs worth of creation of all occupant delivering units
of a country in a predetermined period before deducting stipends for utilization of fixed capital. A creating
unit is considered an inhabitant in a nation if it holds its focal financial interest in the monetary domain of
that country. A nation's financial domain comprises the geographic region. It is regulated by an
administration inside which people, merchandise and capital circle uninhibitedly. The gross domestic
product can be estimated by utilizing three methodologies creation approach (the amount of significant
worth added), the use approach (the amount of definite consumption) and the pay approach (the number of
livelihoods appropriated by occupant maker unit). The results of Tabash & Dhankar's (2014) study show a
relationship between Islamic bank financing and GDP. They additionally tracked down that the extension of
Islamic Finance has made a positive and significant contribution to the development of investment as
estimated by local and foreign investment inflows. Because of these outcomes, they also suggest
policymakers should focus harder on Islamic Finance to stimulate the economy of Malaysia.

3.3 Model Specification

The model is a realistic design that has been simplified to explain the relationship between variables
and understand the dependent variable's value based on the independent variable's value. Therefore, we will
develop the model based on the literature discussed in the previous section. We find that Inflation rate
(INFLAT), return on assets (ROA), return on net assets (ROE), current ratio (LIQ), capital adequacy ratio
(CAR), and Unemployment rate (UM), Shariah Non-compliance Risk (SNCR) and social welfare. In
addition, this research focuses on eight Islamic banks in Malaysia so panel data analysis will be used in this
specification model. Consequently, the model for the hypotheses will be formed as follows:
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LSNCRit = α + β1 LCARit + β2LUMit + εit (5)

The model for the hypothesis two will be formed as follows:
LCARit = α + β1 LINFLATit + β2LROAit + β3LROEit + β4LLIQ + εit (6)
The model for the hypothesis three will be formed as follows:
LUMit = α + β1 LGDPit + εit (7)
Where LSNCR is log shariah non-compliance risk, LCAR is log capital adequacy ratio, LUM is the log
unemployment rate, LINFLAT is the log inflation rate, LROA is log return on assets, LROE is log return
on equity, LLIQ is log liquidity, LGDP is log gross domestic product, α is constant, β is coefficient of the
regression and ε is error terms

3.4 Method of Estimations

3.4.1 Three-stage least squares (3SLS)
The three-stage least squares method is a complete information estimation method for simultaneous
equation models, referred to as 3SLS method. The so-called "complete information estimation method"
refers to using all available information while simultaneously estimating all equations in the model. The
basic idea of this method is to use the estimation error of the two-stage least squares method to construct the
statistics of the covariance matrix of the random disturbance term of the model to perform generalized least
squares estimation on the entire model. The main steps of applying this method are: (1) The model system is
required to be identifiable, and all the defining equations (i.e. identities) are removed; (2) The least-squares
estimation is made on the simplified model of the model; (3) The above estimator is used as a tool Variables
carry out least-squares estimation (namely two-stage least squares estimation) on the model structure, and
calculate the estimation error; (4) Construct the statistics of the variance of the disturbance term with the
two-stage estimation error, and perform generalized least squares estimation. The estimation result of this
method has better asymptotic validity than two-stage least square estimation under certain conditions.
3.4.2 Cholesky decomposition theorem
In order to eliminate the limitations of the LU decomposition and the excessive accumulation of
errors, the method of selecting the principal elements is adopted. But for a special positive definite matrix,
all the principals and sub-forms of the order are non-singular, and all the principals are non-zero, so it is not
necessary to choose the principals. For positive definite matrices, efficient Cholesky decomposition can be
used. It can measure the stability of the model with a very small error to ensure the model's practicality.

4. Results
In this section, the study needs an analysis test to clarify the statement and achieve the study's
objectives. Kunhibava (2012) highlighted that 17 local Islamic Banks existed and operated in Malaysia.
However, not all institutions are transparent and display data publicly, resulting in many data unavailable.
Due to the limitation, the data for this research is based on annual financial reports ranging from 2014 to
2019. It consists of only 8 Islamic Financial Institutions (IFIs) in Malaysia, namely; Affin Islamic Bank
Berhad, Alliance Islamic Bank Berhad, Ambank Islamic Berhad, Bank Islam (M) Berhad, Hong Leong
Islamic Bank Berhad, Maybank Islamic Berhad, OCBC Al-Amin Bank and Public Islamic Bank Berhad. To
conduct the analysis test, the variables are Shariah Non-compliance Risk (SNCR), Capital Adequacy Ratio
(CAR), Unemployment rate (UM), Inflation rate (INFLAT), Return on Assets (ROA), Return on Equity
(ROE), Liquidity (LIQ) and Gross Domestic Products (GDP). The study will test the relationship between
the variables and identify the significant level for those variables. The approach selected for the model is
Three-Stages Least Squares (3SLS), followed by the diagnostic tests, Cholesky Decomposition Theorem, to
ensure the stability of the model and the reliability of the result. After that, the Residual Correlation Matrix
is used to investigate the differences between the actual correlations.
The Three-stage least square method, starts from a paper by Zellner & Theil (1992). In classical
specifications, although structural disturbances may correlate across equations (contemporary correlation),
it is assumed that disturbances do not correlate with the same variance and sequence in each structural
equation. Thus, the classical norm means that the interference covariance matrix in each equation is
diagonal, while the overall covariance matrix of the system is non-diagonal. SNCR, CAR and UM build the
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first model. The dependent variable for the second model is CAR, followed by independent variables such
as INFLAT, ROA, ROE and LIQ. At the same time, UM has been chosen as the dependent variable in the
third model and GDP as an independent variable. The relationship and significant level between the
variables will be identified for these three reduced models.

Table 1. Results of the correlation of SNCR, CAR, UEMPLOY for the first model.
Variable SNCR CAR UEMPLOY
SNCR 1.000 0.1463 0.0868
CAR 0.1463 1.000 0.2706
UEMPLOY 0.0868 0.2706 1.000

The result obtained by ordinary correlation is hoped to be close to 1, proving that the two variables have
a stronger relationship. However, in the correlation of regression (3SLS), the researcher expects that the
exogenous variables do not have a strong relationship. It is because if there is a strong relationship between
two variables X, there is a relationship between X1 and X2, which may also indirectly make X1 or X2 a Y
variable. The rule of 3SLS Regression is that variable X cannot have too strong a relationship between
regressions, and its relationship only stays between X and Y. In other words, both Variable X cannot be
close to 1 in 3SLS Regression. Otherwise, it is proof of multi-collinearity. Thus, Table 1 shows that the
correlation between each variable is not more than 0.2. Indeed, the researcher can identify that the
relationship between the various endogenous variables is not strong, which is why the results obtained in
3SLS can be close to perfect.

Table 2. Results of the correlation of CAR, INFLATION, ROA, ROE and LIQ for second model.
Variable CAR INFLATION ROA ROE LIQ
CAR 1.000 -0.071 -0.238 -0.341 0.079
INFLATION -0.071 1.000 -0.044 0.047 0.072
ROA -0.238 -0.044 1.000 -0.244 0.019
ROE -0.341 0.049 -0.244 1.000 -0.281
LIQ 0.079 0.072 0.019 -0.281 1.000

Table 2 shows the correlation test for the second model is quite satisfactory. Both relations between the
variables are very weak. In the correlation of regression (3SLS), the researcher expects that the exogenous
variables do not have a strong relationship. So, the results of this correlation test perfectly fulfil the
requirement of the regression of 3SLS. The rule of 3SLS Regression is that variable X cannot have too
strong a relationship between regressions, and its relationship only stays between X and Y. In other words,
both Variable X cannot be close to 1 in 3SLS Regression. Otherwise, it is proof of multi-collinearity.

Table 3. Results of the correlation of UEMPLOY and GDP for the third model.
Variable UEMPLOY GDP
UEMPLOY 1.000 0.695
GDP 0.695 1.000

Table 3 captures the correlation test for the third model. The unemployment rate and Gross Domestic
Product (GDP) are close to 1 or 0.7. It means there is a strong relationship between the two variables. A
single movement in the unemployment rate will cause changes in GDP. Therefore, researchers can use the
unemployment rate to examine social welfare through GDP. The relationship between the unemployment
rate and GDP is strong, and GDP can reflect people's social welfare. It can also prove that the unemployment
rate can indirectly affect social welfare. After the correlation test for both models, the next step is identifying
their relationship through method 3SLS.
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Table 4. Result of three stage least square for three model.

Variables Coefficient t-statistic Probability
CAR 0.041036 109.6124 0.000
UM 8.748095 56.7345 0.000
nd
2 MODEL 2.339556 2.61721 0.0098
3rd MODEL -60.27002 -2.995639 0.0032
Durbin-Watson: 0.550279

Table 4 shows that all the dependent and independent variables are significant. 2nd model in the table
represent LCARit = α + β1 LINFLATIONit + β2LROAit + β3LROEit + β4LLIQit, while 3rd model represent
LUNEMPLOYit = α + β1 GDPit. The result shows that CAR and UM have a significant effect at 1 per cent or
0.01. It means the independent variable, CAR and UM are significantly related to SNCR. Any changes in
the two independent variables will affect or impact Shariah's Non-compliance Risk. Then, the second model
shows a probability of less than 0.05 and a significance of 1%. As stated, the variables in the second model:
CAR, INFLAT, ROA, ROE, and LIQ are significantly and have a strong relationship with the first model,
which means the changes in the first model can affect those variables indirectly. In addition, the third model
also shows similar results, with the probability at 0.0032 and significance at 1%. This result is enough to
illustrate the relationship between the various variables. Both models have an inseparable relationship,
whether direct or indirect. A slight change in any one model will affect the other two models. In addition, the
value of Durbin Watson showed at 0.550279. The value of the DW test normally lies between 0 to 4. If the
D-W value is around 2 (between 1.7 and 2.3), there is no autocorrelation. However, the results show a
positive autocorrelation between both variables, and the data deviates from the value 2. It indicates a very
strong positive autocorrelation among the variables.

Table 5. Result of a diagnostic test using Cholesky.

Component Jarque-Bera df Probability

1 4.339783 2 0.1142
2 19.16254 2 0.0001
3 4.494941 2 0.1057
Joint 27.99726 6 0.0001

Cholesky decomposition is an incredible mathematical enhancement procedure that generally utilizes

indirect variable-based math (Krishnamurthy et al., 2020). It disintegrates the Hermitian positive distinct
lattice into the lower triangle framework and its form parts. It can be utilized later to perform arithmetical
tasks ideally. The diagnostic test result showed that the probability for the three models at 0.0001, also
known as significance at 1%. Its means both of the models are normally distributed. This result also brings
out a strong conclusion that these three models are very stable. Identifying the three-layers effect, whether
directly or indirectly, is very suitable, brought from Shariah Non-compliance Risk.

5. Conclusions
Islamic finance has encountered achievements throughout many years as a vital piece of the Islamic life
framework. Islamic Finance currently returns as Modern Islamic Financial Institutions (IFI), which have
filled worldwide. Normally, this number will bounce up to USD 6.5 trillion by 2020. The Financial Stability
Report in 2016, the absolute worldwide resources of IFIs have expanded fundamentally from USD 150
billion in the 1990s to USD 2 trillion. Despite its overall spread, remembering for some Non-Muslim
countries like China, it is noticed that IFIs improvement is profoundly gathered in the Middle East and Asian
countries. So, does an Islamic bank need to exist? This study and research results can explain its effect on a
country. The Shariah law upheld by the Islamic Bank has an inseparable relationship with the social welfare
of the Malaysian people. There is an inseparable relationship between SNCR and CAR, which can also
show that they influence each other, whether they rise or fall. It can also prove that too many SNCR are
distributed as benefits toward social welfare. In the long term, bank operations will be affected. Currently,
Islamic banks are indeed a kind of detached existence. And this research is not to encourage the end of
Islamic banking operations but to understand its inseparable relationship with society and make appropriate
countermeasures after clarifying the relationship.
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The purpose of this study is to identify the relationship between SNCR, CAR and also social welfare.
Then, relate the impact of Shariah Non-compliance funds and bank profits towards Social Welfare in
Malaysia. From the results shown, we can be sure that SNCR can indeed affect bank operations (through
affecting CAR), and if not handled properly, it can even lead to bankruptcy. At the same time, it can also
improve and enhance our country's social welfare. What to say? The above test uses the unemployment rate
and GDP as the proxy, which can also be called mediating variables, to measure social welfare. Previous
studies above can also prove that the unemployment rate and GDP can be used to measure social welfare so
that this statement can be established. All in all, SNCR can cause bank bankruptcy and increase social
welfare.
The purpose of this research has been achieved, and a good interpretation has been obtained. It can be
seen that Islamic finance does indeed have great development potential. Apart from improper operation, the
laws and regulations in Islamic finance can benefit bank users and enhance the country’s social welfare.
When people's social welfare improves, everyone's life will become more comfortable. It is of great help to
the next generation of people. In general, social welfare is improved through Shariah Non-compliance
funds, and the people's living standards are also improved. Then under such high-quality conditions, the
children's educational quality will be improved accordingly. It is the non-indirect impact brought by Shariah
Non-compliance funds by affecting social welfare. Undeniably, this has also made Malaysia much easier on
the road to recovery and economic improvement. However, as the saying goes, water can carry and overturn
a boat. Properly handling this can bring benefits to the people, but if not careful, it may cause a serious loss.

5.1 Recommendation
As mentioned above, excessive SNCR, as a charitable donation, will cause a crisis in bank operations.
So, is the purpose of this research to eliminate Islamic financial institutions? Absolutely no. It is to enable
relevant responsible persons to make protection regulations better. For example, SNCR spending can be
restricted, and Islamic financial institutions can be protected so that even if banks spend too much SNCR,
they can have enough time to recover and avoid the risk of bankruptcy. Azahar & Hanif (2018) and Hassan
et al. (2014) stated that the Takaful and insurance benefits protection plan is an innovative product launched
by the Malaysian Deposit Insurance Corporation (PIDM). It aims to provide clear protection for Takaful
certificates and policyholders to prevent the loss of part or all of the benefits of insurance company members
in the event of failure. The main goal of Takaful and insurance interest protection is to increase public
confidence in the Malaysian financial system by protecting the owners of Takaful certificates and insurance
policies from loss of profits. It is a very successful case done by the government. The people are assured of
having a bank under the asylum to conduct transactions. As a result, the researchers hope to use the results of
their research to allow the third party as a reference to create a regulation that protects explicitly Islamic
financial institutions. In this case, Islamic financial institutions can improve social welfare, but there is no
need to worry about the end of banking operations.

5.2 Limitations of the study

First of all, the sample size of the panel data model in this study is very small, including only 8 Islamic
financial institutions in Malaysia. From 2014 to 2019 (6 years), there were 48 observations. The results will
be more convincing for a large data sample because it covers more observations. Unfortunately, not all
Islamic financial institutions' internal data are transparent and open. That is why the researchers only
selected 8 of the 17 banks as the research objects. Of course, there is no obstacle in collecting the basic
income and expenditure of the bank, but when the researcher is collecting more confidential data, such as
SNCR (as a charitable donation to help people in need), non-performing loan, return on equity, and so on.
This incident posed a challenge to the discovery and became a limitation in our research. Therefore, we can
only collect a very limited time and a very limited of variables to conduct the analysis test.

Author Contributions: Conceptualization, Y.M.L., H.S., and J.S.; methodology, H.S., and J.S.; software, Y.M.L.,
H.S., and J.S.; validation, H.S., and J.S.; formal analysis, H.S., and J.S.; investigation, Y.M.L., H.S., and J.S.;
resources, Y.M.L.; data curation, H.S., and J.S.; writing—original draft preparation, Y.M.L., H.S., and J.S.;
writing—review and editing, Y.M.L., H.S., and J.S.; supervision, H.S.; project administration, H.S.; funding
acquisition, H.S. All authors have read and agreed to the published version of the manuscript.
Funding: This research received no external funding.
Institutional Review Board Statement: Not applicable.
International Journal of Finance, Economics and Business
Vol. 1, No. 2, June 2022, pp.118-131. 130

Informed Consent Statement: Not applicable.

Data Availability Statement: Not applicable.
Acknowledgments: The author would like to thank Universiti Malaysia Terengganu for supporting this research and
publication. We would also like to thank the reviewers for their constructive comments and suggestions.
Conflicts of Interest: The authors declare no conflict of interest.

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