The Role of Equity Financing on the Profitability of Indonesian Islamic Banks

Abstract

Islamic banks provide financing in the form of equity financing and non-equity financing. Equity financing is profit-loss sharing financing which is the main core of Islamic bank business consisting of Mudharabah and Musyarakah. This paper examines the extent to which equity financing affects the profitability of Islamic banks in Indonesia with the control variables consisting of bank-specific variables such as capital adequacy ratio, cost-income ratio, non-performing financing, and macroeconomic conditions such as domestic output, exchange rate. This study employs aggregate data of Islamic banks from January 2010 to December 2019. The estimation method is the Autoregressive distributed lag (ARDL) model. The results prove evidence of the long-run relationship between the dependent andindependent variables. The results show that total equity financing increases Islamic banks' profitability in Indonesia, but only Musyarakah financing significantly boosts profitability. Furthermore, the bank-specific variables affecting profits are capital, efficiency, and nonperforming financing. High capital adequacy ratio (CAR) reduces profit and inefficient Islamic banks and non-performing financing lower profit. Evidence also highlights that worse economic conditions through the economic downturn and sharp depreciation obviously lower the profitability of Islamic banks. These results imply that Islamic banks must capitalize on Musyarakah financing to support the performance of Islamic banks.