CLASSIFICATION AND MANAGEMENT OF NON-PERFORMING LOANS31
Jurnal Teknologi, 51(E) Dis. 2009: 31–56
© Universiti Teknologi Malaysia
CLASSIFICATION AND MANAGEMENT OF NON-PERFORMING
LOANS OF ISLAMIC BANKS AND CONVENTIONAL BANKS: A
MOKHRAZINIM MOKHTAR1 & ZUKARNAIN ZAKARIA2
Islamic banks in Malaysia and conventional banks in the UK and Japan. The objective of this paper is
to investigate if there are differences in the classification and management of non-performing loans in
Islamic banks as a result of the existence of the Investment Account Depositors (IADs). The nature of
profit and sharing loss agreement has made the position of IADs in an Islamic bank unique. This
uniqueness, however, has posed some degree of risk where in case the bank incurs a loss, the IADs are
liable to share this loss. This has made the investment of IADs very risky and is subject to the potential
problem of asymmetric information. This paper finds that the Islamic banks define and manage their
non-performing loans differently from the conventional banks in the UK and Japan. The analysis
shows that even though Islamic banks have special characteristics, the classification and management of
its non-performing loans are quite lenient. This is evidenced in the way non-performing loans are
defined, the way loss provision is made and the level of disclosure made by an Islamic bank.
This paper compares the classification and management of non-performing loans between
Islamic banks; non-performing loans; loss provision; level of disclosure
bank Islam di Malaysia dengan bank-bank konvensional di United Kingdom (UK) dan Jepun. Objektif
kajian adalah untuk menyelidik sama ada terdapat perbezaan dalam klasifikasi dan pengurusan pinjaman
tak-berbayar yang dipratikkan oleh bank Islam hasil dari kewujudan Akaun Deposit Pelaburan (IAD)
di bank berkenaan. Peruntukan perkongsian untung rugi seperti mana yang terdapat dalam IAD di
bank Islam adalah sesuatu yang unik. Keunikan ini, walau bagaimanapun mempunyai risiko di mana
dalam kes bank mengalami kerugian, maka IAD akan turut sama menanggung kerugian tersebut. Ini
menjadikan pelaburan dalam IAD sangat berisiko dan tertakluk kepada maklumat asimetri. Kertas ini
mendapati bank Islam mendefinisikan dan mengurus pinjaman tak-berbayarnya secara berbeza
berbanding dengan bank-bank konvensional di UK dan Jepun. Analisis menunjukkan walaupun bank
Islam mempunyai ciri-ciri khas tapi klasifikasi dan pengurusan pinjaman tak-berbayarnya adalah lebih
longgar. Ini dibuktikan melalui cara di mana pinjaman tak-berbayar dan cara peruntukan kerugiannya
didefinisikan dan juga tahap pendedahan maklumat kewangan yang dilakukan oleh bank Islam.
Artikel ini membandingkan klasifikasi dan pengurusan pinjaman tak-berbayar antara
Bank Islam; pinjaman tak-berbayar; peruntukan kerugian; tahap pendedahan maklumat
Bank Kerjasama Rakyat Malaysia Berhad (Bank Rakyat)
Department of Management, Faculty of Management and Human Resource Development, 81310
UTM Skudai, Johor
Email: email@example.com firstname.lastname@example.org
MOKHRAZINIM MOKHTAR & ZUKARNAIN ZAKARIA 32
In a conventional banking system, the bank obtains fund by borrowing from its
depositors at an interest rate. The bank uses the funds to make profits by extending
loans and also by investing in securities. The profit made by the bank is through the
differences between the borrowing interest rate and the lending interest rate. Unlike
conventional banks, Islamic banks do not operate on an interest rate system. Thus, to
make a profit, Islamic bank must invest the funds by extending financing. Since they
are not able to charge interest, Islamic banks use various types of contract like cost plus,
and profit and loss sharing (PLS), which are consistent with Islamic principles. The
funds for the financing comes from the Islamic bank’s own equity, customers’ deposits
in current accounts, customers’ deposit in saving accounts and customers’ deposit in
investment accounts (hereafter referred to as Investment Account Depositors – IAD).
Funds from the depositors mingle with shareholders’ funds and the bank use the
funds in the same investment portfolio. However, the shareholders’ fund would be
used to fulfil legal requirements while most of the deposits will be used for extending
financing. Current Accounts and Saving Accounts are guaranteed whereas Investment
Accounts do not guarantee capital because they are based on the profit and loss sharing
agreement. The IADs are entitled to share in the bank’s net profit or loss and this is
based on a profit sharing ratio of a certain pre agreed percentage. In case of loss from
the activities of giving out financing, the IADs can lose all of their investments. Since
deposits other than IADSs are guaranteed, the loss flows to the IADs first, with any
remaining flowing to the shareholders of the bank. Only when the loss is major that it
will finally flow to the rest of the depositors. The IADs actually act as a cushion for the
bank in case of a loss. The position of IADs in an Islamic bank is quite unique. This
is because even though the IADs have invested in the bank and may suffer losses, they
are not shareholders. Since they are not shareholders the IADs do not have special
rights like voting rights and therefore cannot influence the investment decision of the
Islamic bank. The nature of profit and sharing loss agreement has made the position
of IADs in an Islamic bank unique. However, this uniqueness has posed some degree
of risk for the IADs. In case where the bank incurs a loss, the IADs are liable to share
this loss. This has made the investment of IADs very risky and is subject to the potential
problem of asymmetric information.
The objective of this paper is to investigate the policy on classification and
management of non-performing loans in Islamic banks in Malaysia. It will compare
the policy in the classification and management of non-performing loans with the
policy adopted in the UK and Japan. Specifically, this paper investigates whether or not
the existence of IADs has resulted in a stricter approach to the classification and
management of non-performing loans in Islamic banks in Malaysia. The unique position
of IADs in Islamic banks has lead to several questions. Firstly, are there any differences
in the policy pertaining to non-performing financing in an Islamic bank so that the
IADs will be protected from any loss? What are the differences between the approaches
CLASSIFICATION AND MANAGEMENT OF NON-PERFORMING LOANS33
used by Islamic banks in Malaysia and conventional banks in UK and Japan in
classifying and managing their non-performing loans? Secondly, are there adequate
disclosures to the IADs on the situation of non-performing loans that the bank has?
2.0 LITERATURE REVIEW
Fama (1970) introduces a model of efficient capital markets. An ideal market is a
market where prices provide accurate signals for resource allocation. He divided the
markets into three categories depending on the nature of the information subset of
interest. They are the strong-form, semi-strong-form and weak form. A strong-form
efficient market model is where the prices are assumed to fully reflect all available
information. A semi-strong-form is where the prices are assumed to fully reflect the
publicly available information and the weak-form where the prices are reflected from
available historical information. According to Abalkhail and Presley (2001), the lack
of information transfer between investors and entrepreneur exposes the investors to
the risk of adverse selection and moral hazard. Information seems to be a very important
element in a financial market. Stiglitz (1985) suggested that a capital market is
informationally efficient when the prices reflect the available information.
In relation to the importance of information, the most important information for the
IADs would be on the non-performing financing of the bank that they invested in. As
suggested by Beattie et al. (1995) bad debs are by far the most common cause of bank
failures. Bank failures are always viewed to be more damaging than any other types of
business failures because it is feared that the failure might be contagious and as a
result, the whole financial system might collapse. Kaufman (1996) suggested that the
reason for this is because banks are closely entwined financially with each other through
lending and borrowing from each other, payments clearing system that the failure of
one bank is likely to spill to other banks more quickly. The best example of the
adverse effects of uncontrolled classification and management of non-performing loans
is Japan. Insufficient provisioning and public disclosure have been identified as factors
that concealed the actual levels of the non-performing loans in Japan (Nakaso, 2001).
With regard to the issue of non-performing loans in Islamic banks, in September 2000,
Pakistan has set up the “Corporate and Industrial Restructuring Corporation” (CIRC)
to address the issue of non-performing loans and risk aversion (State Bank of Pakistan,
2002). A second committee on Revival of Sick Units (RSU) was established to
restructure and revived problematic loans. Pakistan has also promulgated the Financial
Institution (Recovery of Finance) Ordinance to expedite recovery of non-performing
loans by foreclosure. In Bangladesh, the amount of bad debts of the Islamic banks
grew from 18% in 1996 to 20% in 1997 (Sarker, 1999).
In order for the IADs to be protected, there should be an adequate classification and
management of non-performing loans and adequate disclosure on the level of the non-
performing loans of the banks to the IADs. This is important because the nature of the
relationship between the IADs and the bank entail the sharing of losses. Hence if
MOKHRAZINIM MOKHTAR & ZUKARNAIN ZAKARIA34
these two are inadequate, it may lead to potential bank failure and the IADs may risk
losing their investments. Therefore, a transparent approach in the management of non-
performing loans in Islamic banks is very crucial as it may reduce the probability of
IADs losing their investments.
3.0 CLASSIFICATION AND MANAGEMENT OF NON-
The regulations in each country differ and as a result the classification and management
of non-performing loans differ from one jurisdiction to another. The treatment of non-
performing loans, loss provision and disclosure are different as well. In general, however
different the regulations are in every country, the objective of regulation in the end is to
ensure the bank’s soundness. In this section, an analysis is made of the classification
and management of loss provision in Malaysia, Japan and the United Kingdom.
3.1 Definition of Non-Performing Loans
The Basle Committee on Banking Supervision does not have an exact definition of
non-performing loans, but in the Consultative Documents, January 2001, under Rules for
Corporate Exposures for minimum requirements for corporate exposures, section 272,
it is mentioned that:
A default is considered to have occurred with regard to a particular obligor
when one or more of the following events have taken place:
It is determined that the obligor is unlikely to pay its debt obligations (principal,
interest, or fees) in full;
A credit loss event associated with any obligation of the obligor, such as a
charge off, specific provision, or distressed restructuring involving forgiveness
or postponement of principal, interest or fees;
The obligor is past due more than 90 days on any credit obligation; or
The obligor has filed for bankruptcy or similar protection from creditors
This definition however is not intended to affect the bank’s legal rights and
remedies should a borrower fail to meet his or her obligations under a credit
agreement. It is also not intended to establish or alter accepted accounting
The Accounting, Auditing and Governance Standards for Islamic Financial
Institutions (AAOIFI) does not define doubtful receivables. AAOIFI was established
in 1991, led by four major Islamic banking groups and the Islamic Development Bank
(IDB). Its objective was to promulgate international accounting and auditing standards
to be used by Islamic financial institutions internationally (AAOIFI, 2004).
CLASSIFICATION AND MANAGEMENT OF NON-PERFORMING LOANS53
provisioning is intended to cater for the tax deduction. In other words, the levels of
provision for both specific and general provision are little since the amounts that are
tax deductible are little too. The tax rules are likely to be the reason behind the lack of
provision in Japan (Yamawaki, 1996). As a result Japanese banks were faced with large
amount of write-off and provisioning during the economic downturn. Specific and
general provisions are tax deductible in Malaysia. In the profit and loss statement, both
provisions are treated as other expenses and are deducted from the revenue of the
In Malaysia, the BNM gives guidelines on the valuation of security for the purpose of
provision. While in the UK and Japan no official guidance is given. In the UK the
policies on the valuation security is based on the banking industry practice. However,
in Japan, the management usually discuss with the representatives of the MoF.
The level of disclosure of non-performing loans by financial institutions in Islamic
banks in Malaysia is limited compared to the information on non-performing loans
that are disclosed in HSBC’s or Barclays’s financial statement. This can be seen from
the limited information on non-performing loans that can be obtained from the annual
report of BIMB as compared to the information provided by HSBC (UK) and Barclays.
In the BIMB report one can only see the movement of non-performing loans and
movement of provision for the non-performing loans in the past 12 months. There is a
section on the percentage of non-performing loans to performing loans but there is no
detailed information on this. The only information one can get is on the amount of
non-performing loans for the year. There is no breakdown of the non-performing loans
and it is not analysed by either the type of loans or customers. This information is only
understood by professional and does not disclose pertinent information for stakeholders
Unlike the method of disclosure by some banks in the UK where the policy on risk
management of the financial institution is made known to the public in a special
section in the annual report, a person reading the financial report of an Islamic bank in
Malaysia would not be provided with such information. There is no information on
the bank’s policy on analysing credit risk, liquidity risk, market risk and other related
risk. There is also no information on how these risks are managed by the bank. The
limit of risk that the bank is taking and how these risks are monitored is also not
mentioned. This is quite unusual considering that the IADs share with the Islamic
banks the profit and loss; they have limited information on the risks to which they are
exposed. This lack of transparency creates moral hazard in such an institution.
Looking at the financial report of HSBC (UK), the total loans are broken down by
the type of customers and geographical region. Analysis is for the past 5 years. The
types of customer are personal, corporate and commercial, and financial. Each type is
further broken down into the type of loans like residential, mortgage and etc. Information
on amount of recoveries written off is broken down into the type of customers and also
for the period of 5 years. One can see clearly if the amount of non-performing loans
and recoveries are increasing or decreasing for the past 5 years. There are detailed
MOKHRAZINIM MOKHTAR & ZUKARNAIN ZAKARIA54
explanations on what specific provisions, general provision and other related items on
non-performing loans are. The analyses of risk management are comprehensive.
As an international bank, the movement of loss provision reported by HSBC (UK)
is by region and is also broken down by the type of customers. Therefore, one can see
which type of customers that has a large amount of loss provision and how much has
been recovered in the past 5 years. Furthermore, there is also information on loans that
might be at risk of becoming non-performing loans in the future. This sort of information
is accessible to the public. By doing this, not only do the depositors know but it would
also encourage the bank to take action, so that these loans will be monitored. Barclays
also undertakes the same method of disclosure even though the analysis is only for the
past 12 months.
As for Japan, there is good progress in terms of disclosure by financial institutions
after the economic crisis. In the case of major banks under Zenginkyo, they must disclose
the following information: loans to failing companies, loans on which interest payment
is delayed, loans on which interest payment is partially or totally waived and loans to
firms whose management includes the participation of the lending bank
In addition, the MoF in Japan also provides a classification of debt for disclosure to
the public. The information that must be disclosed under the MoF is based on 4
categories of assets. Even though there are two different sets of disclosure, this shows
that the Japanese authorities realised the importance of disclosure and is now requesting
banks in Japan to disclose information of non-performing loans to the public.
The policy on loss provision that is not applicable to Islamic banks is related to the
capitalisation of interest. While conventional banks can capitalise on the interest of
non-performing loans by crediting them to the interest in suspense, Islamic banks are
not allowed to capitalise on the profit they are supposed to make if the loan is performing.
Profit of Islamic banks can only be recognised as income when it is received.
5.0 CONCLUSION AND RECOMMENDATION
The study of the classification and management of non-performing loans in Islamic
banks in Malaysia finds that the Islamic banks define and manage their non-performing
loans differently from the conventional banks in the UK and Japan. However, applying
the same guidelines designed for conventional banks would make it difficult for Islamic
banks to determine the timing to declare the financing as non-performing. For example,
a loan is considered non-performing when the loan has been in default for six months
or more. The same classification may be suitable for Murabahah (cost-plus) financing,
but for profit and loss sharing activities this definition may not be suitable. A more
appropriate definition is needed to determine their classification as non-performing.
Project under the profit and loss sharing provide uncertain return as they depend on
the profitability of the project. The return may be less than expected or even fails. As
different projects give different timing of return to investment, a standard definition of
CLASSIFICATION AND MANAGEMENT OF NON-PERFORMING LOANS55
non-performing should not be applied. Therefore a suitable regulatory framework is
necessary to avoid the unwanted implications of non-performing loans.
In respect of the level of disclosure, IADs share very little knowledge of the non-
performing loans faced by the bank. There is little information that can be derived
from the annual report of the Islamic banks in Malaysia. They do not know what
actions are undertaken by the Islamic banks to control or reduce the amount of non-
performing loans. When little information is given, the IADs may not be aware that
their investments or savings can be affected by the percentage of non-performing loans.
They may not be aware that uncontrolled non-performing loans would lead to the
failure of a financial institution. It is only when they are given no return to their
investments or when they are informed that their investments are making losses that
they will realise the repercussion of non-performing loans. By that time it will be too
late to do anything other than face the losses. Lessons must be learned from Japan’s
forbearance policy in their classification and management of non-performing loans.
Information disclosure is very important in an Islamic banking system because of
the risk sharing characteristics and the absence of protection for IADs. The more
reliable is the disclosure, the more are IADs or other users able to make an accurate
assessment of the Islamic bank’s financial position. A clear information disclosure
will allow depositors especially IADs to decide which bank they want to deposit their
funds into. Important information, particularly on the non-performing loans is very
important because investors would like to know the risks that their investments are
exposed to. This will allow depositors to monitor the bank and as a result could help
to discipline the bank.
The special characteristic of an Islamic bank calls for an appropriate regulatory
framework specially designed to accommodate its characteristics in addition to what
has been designed for conventional banks. Appropriate information disclosure will
help regulators understand the objectives, strategies and the risks that a bank is exposed
to. This will prevent misleading information that can cause the instability of the financial
system. Regulators or policymaker should be concerned if there is lack of control or
disclosure from a bank because they act as representative of depositors. There is a
need to protect the IADs from potential moral hazards and adverse selection arising
from asymmetric information. The IADs do not have voting rights because they do
not own the equity of the Islamic bank and therefore cannot participate in the investment
decisions. The objectives of regulating banks are to ensure that there is no moral
hazard, depositors’ protection, avoid systemic risk and investors’ protection (Dale and
Wolfe, 1998). Therefore, regulators should be concern when any of this is absent.
Regulations of Islamic banks must emphasize the classification and management of
non-performing loans. Therefore, BNM should tighten its supervision and regulation
of Islamic financial institutions; to ensure their level of supervision is equivalent to that
of the conventional banks, albeit taking into account its compliance with Islamic laws.
Study by Demirguc-Kunt et al. (2006) show that sound banking is associated with
MOKHRAZINIM MOKHTAR & ZUKARNAIN ZAKARIA56
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