1.

0 INTRODUCTION

Background of research

The banking sector in Malaysia has come a long way over the past few decades.
Different segments such as commercial, investment and Islamic banking have made
significant inroads in the industry. The creation of derivatives has served as a useful tool for
managers in banking sector to mitigate loss. Financial institutions use derivatives as a risk
management tool to hedge on-balance sheet transactions through speculating movements in
exchange rates, interest rates, and commodity prices. The benefits realised from using
derivatives have encouraged banks to improve their efficiency of derivative usage. Currently,
employing derivatives as risk hedging tools have become prominent, especially in financial
institutions in developed countries. Being a developing country, Malaysia have yet to
experience extensive widespread employment of derivatives, as equities remained relatively
more desirable among local investors.

The purpose of this paper is to study whether the use of derivatives by financial
institutions in Malaysia affect their efficiency. This study is based on six Malaysian banks,
RHB Bank, OCBC Al-Amin, Public Bank and Public Islamic Bank. The sample consists of
three conventional banks and three islamic banks. Two stretches of time are selected to be
studied separately. This paper first examines the impact of derivatives usage on banks’
efficiency over the period of 2010-2017, and then further look into the period 2015 to 2016
when the Chinese stock market turbulence took place.

The Chinese Stock Market Crash: Background and its relevance to Malaysian Financial
Institutions

The Chinese stock market turbulence began when the stock market bubble popped in
late 2015, lasting until the mid of 2016. During this period, stocks have plunged 30% in
weeks, firms have suspended their share trading. This is because the trading population in

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China is rather unique as compared with other countries (The Economist, 2015).
Consequently, rumours and speculations played a more significant role as the reason behind
making investment decisions rather than considering the actual economic factors (Fahey &
Chemi, 2015). As a result, the Chinese market has created a trend of impulsive buying and
overvaluation in the market which then led up to the crash.

Figure 1
Shanghai Composite Stock Market Index historical price
Source: Forbes

SSE Composite Index, the largest stock exchange in China, is an ideal benchmark to
express China’s overall share market condition as it makes up all the shares that are being
traded in the Shanghai Stock Exchange. Figure 1 exhibits the stock market in China tumbling
and experiencing a remarkable decline from the end of 2015 until July 2016. China is a
trading nation where international trade makes up a notable portion of its economy. Human
capital is the country’s most crucial resource. China’s large population made economies of
scale possible, giving China a competitive advantage against other developed countries in
manufacturing exports for being able to produce large quantities of products at low cost.
Being the world's second largest economy in terms of nominal GDP, China’s population’s
demand for imported goods grew rapidly. Thus, China has become one of the world's largest
economies by purchasing power parity.

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 Figure 2
Malaysia’s top 15 trading partners (2018)
Source: World’s Top Exports

As seen on figure 2, China is one of the largest Malaysian’s exports purchasing

countries. In 2018, China has purchased 13.9% of Malaysian total exports, contributing
US$34.4 billion to Malaysian GDP (Workman, 2019). Being one of Malaysia’s most crucial
trading partners, it is evident that China’s stock market crash could greatly affect Malaysian
economy. This is supported by a study conducted by Sufian and Habibullah, (2012). This
study implied that when a country’s stocks are facing turmoil, the instability in the share
market can lead to a fall in investors’ wealth and consequently decreases the nation’s
expenditure. This can be seen in the case of China, for instance, when the country’s wealth
decreases, expenditure capacity is reduced and hence the demand for imported goods will
fall. Besides that, the effect of this slump has spilled over into other markets. This is because
in order to cover margin calls, Chinese investors had to sell other assets to raise funds. As a
result, the slump extended beyond stock markets, whereby emerging-market currencies like
Malaysian Ringgit tumbled and prices of commodities such as oil, silver and gold were
greatly affected as well. According to Sufian and Habibullah (2012), this would negatively
impact the profitability of banks as turbulence in stock markets would lead to lesser spending
and lesser investments made in the affected country, which then causes fall in profit made by
banks from giving out loans. On the other hand, Nikolaidi and Stockhammer (2017) however,
argued that when people reduce their spending and opted to increase their savings at the same
time, financial institutions can then generate more profit through leveraging instead.

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Derivatives usage background

Banks in Malaysia are exposed to different types of risks, for instance, interest-rate
risk, exchange rate risk, market risk and unsystematic risk. Sinkey and Carter (2000)
explained that banks that use swaps, futures and options can effectively reduce interest-rate
risk. On the other hand, Shyu and Reichert (2002) later discovered that the usage of options
tend to increase all types of risks, especially the interest rate risk.

In short, the questions that remain unresolved are: Does derivatives usage improve
efficiency of financial institutions in Malaysia? Is the efficiency effect of derivatives usage
alike among conventional banks and Islamic banks? The answers to these questions are
crucial to managers as well as shareholders of all financial institutions. These answers are
also essential to bank policy-makers such as Bank Negara Malaysia and regulators such as
the Securities Commission Malaysia in order to create a well-guarded banking system
capable of avoiding any catastrophe in financial institutions. By studying the efficiency of
derivatives usage during the recent seven-years, as well as during the period of Chinese stock
market crisis, this research focuses on explaining the factors affecting derivative asset of
banks and its relationships.
2.0 LITERATURE REVIEW

Dependent Variable

2.1 Derivative Financial Asset (DA) Usage as a measure of Banks’ Efficiency

The dependent variable of this study, the derivative financial asset (DA) is
represented by the total value of a bank’s usage and trading of derivatives such as foreign
exchange-related contracts, interest rate-related contracts and equity-related contracts.
Derivatives are financial instruments where their values are derived from the underlying
assets such as equity, commodity, currency, and bond. The two most common derivatives are
futures and options. Banks use interest rate swaps to hedge against interest rate risk, and uses
foreign currency derivatives to reduce its exposure towards foreign currency risk. Stock
market is highly exposed to volatility risk. High volatility signifies that stock prices is
capable of changing substantially over a short period of time. Financial crises such as the

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2015-16 Chinese stock market crash may also be the reason behind fluctuations in the stock
market. Derivatives function as a contract between two parties who agreed on the price of a
specific asset based on the predicted fluctuations. The trading of the derivative is then carried
out over-the-counter or on an exchange.

The role of derivatives in banking industry has become increasingly crucial in the last
decade. Ferreira and Pinheiro (2008) uncovered that banks employ derivatives for the
purpose of hedging risk instead of speculating. On the other hand, another recent study
conducted by Huan and Parbonetti (2019) argued that the increase of banks’ usage of interest-
rate derivatives has a positive relationship with the increase of interest rate risk exposure. A
recent paper by Alnassar and Chin (2015) finds that by using derivatives, banks experience
growth in profits due to the increase in lending. Another study conducted by Abdul and
Mohamed (2006) revealed that the structure of ownership and corporate governance of banks
plays a significant role in affecting the bank’s derivatives usage.

There are many elements capable of influencing Malaysian banks’ derivative assets
values. Finance theory implies that the imperfections of capital market has pushed financial
institutions in Malaysia to use derivatives to enjoy the benefits of hedging, such as reduced
tax liability, a fall in agency cost and reduced expected loss during financial crisis (Infante et
al., 2018). The use of financial innovations, in this case derivatives, has allowed financial
institutions to enhance their funds buffers and thus, increases their risk tolerance (Shen &
Hartarska, 2018). Hence, with the proper use of derivatives, banks in Malaysia can reduce
financing costs and agency costs. As a result, their efficiency will improve.

Independent Variables

2.2 Intangible Asset (IA)

Ho (null hypothesis): Intangible Assets income does not affect the value of derivative assets.

H1 (alternative hypothesis): High Intangible Asset values may have a negative effect on the
value of derivative assets.

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 Intangible assets, such as intellectual properties ( i.e. patents, copyrights, goodwill and
trademarks) refers to banks’ long-term resources that usually does not possess any physical
presence, and have an unpredictable future value or benefits. Due to this, intangible assets are
recorded at cost in balance sheets, which is the value when they were originally purchased
and these values are never adjusted over time regardless of the change of its benefits in the
future.

Nevertheless, other than intangible assets, derivative assets is also a component which
makes up the ‘total assets’ segment of a balance sheet. With the ambiguity of the actual value
of intangible assets, banks have an incentive to take advantage to manipulate the value of
intangible assets in its balance sheet to increase the amount of its total assets, in order to
cover up the fall of derivatives assets value (Abdullahtif, 2016). As a result, a higher value of
intangible assets may suggest a decrease in derivative assets value.

2.3 Net Cash Flow (NCW)

Ho (null hypothesis): Net Cash Flow does not affect the value of derivative assets.

H1 (alternative hypothesis): Net cash flow is negatively associated with the value of
derivative asset.

Net cash flow measures the amount of money gained or lost by banks in a year by
subtracting cash outflows from their cash inflows. Net cash flows of banks can be observed in
the cash flow statements. This variable is an indicator of a bank’s financial strength,
expressing the bank’s ability to generate positive cash flow, operate, grow, reduce debts, and
raise the level of shareholder value. Banks with long-term positive net cash flows are
financially healthy and capable of meeting their short-term obligations without needing to
liquidate their assets (Masihabadi et al., 2015). When banks use derivatives to hedge, they
can reduce the volatility of their cash flow and pay out greater levels of income as dividends,
as well as ensuring sufficient cash flow available to make debt payments to their
bondholders.

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 Net cash flow is capable of influencing a bank’s derivative financial asset’s value.
Accounting theory suggests that while a bank’s positive cash flow may signify that the bank
is strong in generating cash inflow, on the other hand, the huge positive cash flow could
imply an excessively defensive behavior of the bank. This is confirmed by the study
conducted by Casey and Bartczak (1985), proving inefficiency of business operations take
place when a firm holds excessive cash in hand, it is not fully its available utilizing funds for
expansion. In other words, short-term shortage in cash flow may indicate that a company has
recently used a large portion of funds for business expansions such as construction of new
plant or purchase of new equipment. Once the investment begins to generate profits, the
higher possible cash inflow will outweigh the effects of short-term weak cash flow. The
inefficiency in funds allocation can limit the potential growth of businesses. In short, the
more efficient the managers in banks in Malaysia are in allocating funds of the bank in order
to generate higher profits, the lower the net cash flow, and hence the lesser amount of
derivative assets.

2.4 Net Interest Income (NII)

Ho (null hypothesis): Net interest income does not affect the value of derivative assets.

H1 (alternative hypothesis): Net interest income is negatively associated with the value of
derivative asset.

Banks’ net interest income derived its value from the difference between revenue
generated from the banks’ assets and the expenses incurred from liabilities. Banks’ assets
include all types of personal and business loans, mortgages and securities; whereas their
liabilities are the customer’s deposits. Banks gain interest income from its assets and are
required to make interest expenses to depositors. Thus, the excess revenue gained is the net
interest income (Westcott, 2018). For a bank to gain higher net interest income, banks may
increase its lendings to raise its interest earnings or accept less deposits to reduce interest
expenses. If this happens, the assets of the bank would fall. The negative relationship
between a bank’s net interest income and its derivative usage can be observed when the
reduced assets led lesser funds available for banks to participate in derivatives trading. In

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other cases, banks could even retreat from derivative usage in order to fully pursue the
expansion of its net interest income.

2.5 Leverage (LEV)

Ho (null hypothesis): Leverage does not affect the value of Derivative Assets.

H1 (alternative hypothesis): There is a positive relationship between Leverage and the value
of Derivative Assets.

The leverage ratio (aka debt ratio) measures banks’ total liabilities as a percentage of
its total assets. As mentioned above, the assets of a bank includes the interest income
received from customers through loans and its liabilities are the interest payments to be paid
to depositors. The key concept of how banks generate income is built about the network
where banks borrow money from depositors, and at the same time lend out these funds to
borrowers (Ryoo, 2013). In other words, depositors are the bank’s creditors and loan
borrowers are the debtors. Leverage ratio expresses the financial leverage of banks, whereby
banks with high debt ratio have higher amount of liabilities borrowed from depositors relative
to the assets that is lent out to borrowers. For instance, if a bank has a debt ratio of 0.5, this
means that its creditors own 50% of the bank’s assets while the shareholders own the
remainder assets. The higher the debt ratio, the more leveraged a bank is. Debt ratio of banks
should positively affect the value of derivative assets, because with higher leverage, more
resources are employed to generate assets for the bank (Jakab & Kumhof, 2014).

2.6 Foreign Direct Investment (FDI)

Ho (null hypothesis): Foreign Direct Investments do not affect the value of Derivative
Assets.

H1 (alternative hypothesis): Foreign Direct Investment has a positive effect on the value of
Derivative Assets.

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 FDI inflows into Malaysia is identified as another important factor affecting value of
derivative assets of banks. FDI is the net inflows of a foreign company’s investment towards
a locally-based company. FDI is a key source of capital, managerial expertise and
technological advancements in Malaysia (Abbas et al., 2011). Nowadays, capital funds are
able to move across country borders at ease. In order to achieve a diversified portfolio,
financial institutions would usually hold various assets of different regions across the globe
within its portfolio. Doing so can reduce the bank’s exposure to political risk and currency
risk that affects a specific country. As more foreign investors allocate funds to be saved in
banks in Malaysia, banks would have more available funds to engage in derivatives trading
activities.This suggests that FDI could have a positive effect on derivative asset value.

2.7 Gold Price (GP)

Ho (null hypothesis): Gold Price does not affect the value of Derivative Assets.

H1 (alternative hypothesis): There is a positive relationship between the Gold Price and value
of Derivative Assets.

Gold price reflects the state of a country’s economic health. As gold price increase
drastically, it signals an economic downturn. Zakaria (2018) found that gold as an alternative
to investments during financial crises is a highly effective portfolio diversifier due to its low
to negative correlation with most of the major asset classes Also as inflation rises, the real
income of people would fall and people would therefore, prefer to store their wealth in the
form of gold. So, when inflation is high, gold becomes a great tool to hedge against the
market uncertainties. As derivatives assets are also used to hedge against uncertainty and
volatility in the financial market, it can be said that a positive relationship exists between the
price of gold and the value of derivative assets (Beckmann et al., 2018).

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3.0 METHODOLOGY AND PROCEDURE OF ANALYSIS

3.1 Data and Data Sources

The sample consists of six banks in Malaysia, quoted on the Kuala Lumpur Stock
Exchange (KLSE). The data sample consists of 50% commercial banks and 50% of Islamic
banks. This study adopts a quantitative approach and hence uses secondary data, which are
extracted from the annual reports published by the selected banks over the period of 2010-
2017. The annual reports are obtained from the Bursa Malaysia website, providing
information on: values of derivative assets, net interest income, value of intangible assets and
leverage ratio. The remaining secondary data of this study: the price of gold and Malaysia’s
annual FDI inflows were collected from the World Bank, a reliable source of data collection.

3.2 Method of Analysis

The information gathered is analysed based on regression analysis, using eViews.

3.3 Specification of Empirical Models

The model is specified below:

DAt = β0 + β1(IA)t + β2(NII)t + β3(NCW)t + β4(LEV)t + β5(FDI)t+ β6(GP)t+ εt

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 For analysing the period during Chinese stock market crash, due to the limited
number of periods as well as the combination of cross-sectional data and time-series data, the
OLS regression technique is not suitable. The method of analysis involves panel data
regression techniques. Hence the specific model for the six banks during 2015-16 is as below:

DAi,t = β0 + β1(Ia)i,t + β2(NII)i,t + β3(NCW)i,t + β4(LEV)i,t + β5(FDI)i,t + β6(GP)t,i + εi,t

4.0 RESULTS AND DISCUSSION

4.1 Evaluating The Quality of The Regression Equation

The quality of regression is to be examined by measuring the overall fit of the

estimated model before accepting the validity of regression results. The values of R 2 of all
the OLS regressions are above 0.9, this indicates that the model explains more than 90% of
the variability of the response data around its mean.

4.2 Regression Analysis

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 4.2.1 Results and Findings for period 2010-17 (Public Bank Berhad)

Figure 3
Estimated Result for Public Bank Berhad

As seen in Figure 3, all independent variables are significant, having p-values of more
than 0.05. Besides, having the highest observed coefficient value, gold price is said to have
the highest influence on the values of derivatives assets.

4.2.2 Results and Findings for period 2010-17 (Public Islamic Bank Berhad)

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 Figure 4
Estimated Result for Public Islamic Bank Berhad

In figure 4, all independent variables are significant, having p-values of more than
0.05. Gold price again, is said to have the biggest influence on the bank’s value of derivative
assets.

4.2.3 Results and Findings for period 2010-17 (OCBC Bank (M) Berhad)

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 Figure 5
Estimated Result for OCBC Bank (M) Berhad

In figure 5, all six independent variables are significant, having p-values of more than
0.05. Gold price, once again, has the biggest influence on OCBC bank’s value of derivative
assets.

4.2.4 Results and Findings for period 2010-17 (OCBC Al-Amin)

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 Figure 6
Estimated Result for OCBC Al-Amin

All six independent variables are significant, having p-values of more than 0.05. Gold
price is the most significant explanatory variable for having the highest coefficient value, and
therefore has the biggest influence on OCBC Al-Amin’s value of derivative assets.

4.2.5 Results and Findings for period 2010-17 (RHB Bank Berhad)

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 Figure 7
Estimated Result for RHB Bank Bhd

All six independent variables are significant, having p-values of more than 0.05.
Consistently, gold price is the most significant explanatory variable for having the highest
coefficient value, and therefore has the biggest influence on RHB bank’s value of derivative
assets.

4.2.6 Results and Findings for period 2010-17 (RHB Islamic Bank Berhad)

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 Figure 8
Estimated Result for RHB Islamic Bank Bhd

All six independent variables are significant, having p-values of more than 0.05.
Consistently, gold price is the most significant explanatory variable for having the highest
coefficient value, and therefore has the biggest influence on RHB Islamic bank’s value of
derivative assets.

4.3 Results and Findings During the 2015-16 Chinese stock market crash period

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 Figure 9
Estimated Result for 6 Banks Panel Data during Crisis Period

The figure above indicates that all six independent variables are significant, having p-
values of more than 0.05.

The result shows that across all significant independent variables, foreign direct
investment inflows (FDI) is the significant explanatory variable associated with the value of
derivative assets. In other words, during the 2016-2016 Chinese stock market crash, FDI has
the biggest influence on majority of Malaysian Banks’ derivative assets values.

4.4 Summary of Overall Banking and Banking Derivative Performance from 2010-2017

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 Table 1
Most Significant Independent Variables over the period of 2010-2017

4. 5 Best Banking Performance

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4.6 Discussion

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 The findings of this study have important implications on derivative usage of banks in
Malaysia. In short, among all the selected banks over the period of 2010-2017, Gold Price
(GP) has emerged as the most significant explanatory variable. This observation conforms to
the findings of a recent study conducted by Gaspareniene et. al. (2018) suggesting that gold is
a highly effective portfolio diversifier to hedge against market uncertainties. Although the
findings of this paper implied that FDI is most impactful factor during the 2015-16 Chinese
stock market crash, Nm (2018) has however pointed out that when equities are under stress
and are falling rapidly in value, a negative relationship between the gold price and equities
can usually be observed. Thus, proving the significance of the variable during financial crisis.

Besides, gold also generally performs well during geopolitical turmoil. For instance,
the values of gold was boosted during the North Korea crisis, a period of heightened tension
between North Korea and the United States, which took place throughout 2017 and lasted
until the beginning of 2018.

Figure 10
Gold Price in MYR/oz from 2015-2018
Source: goldprice.org

This conflict started with North Korea conducting missile and nuclear tests to
demonstrate its weapons capabilities to the world, leading to fears throughout the world about
a possible war. As a result, the price of gold increased rapidly during the entire conflict
period and continued to grow until the disagreements between the two countries subside.
Crises such as wars, which have a negative impact on prices of most asset classes, yet have a

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great positive impact on gold prices, since the demand for gold increases during this period
as a safe haven for parking funds (Tripathy, 2016). It is evident that gold is capable of being
an indicator of the global market condition, and at the same time is capable of effectively
protecting one's portfolio from volatility. When an increase in gold price is observed, this
means that the global market is faced with volatility. Banks should take this as a signal to
increase their derivative assets to hedge the risk.

All in all, gold price to all intents and purposes, indeed is the most significant factor in
influencing the value of derivative assets. This conclusion is strong and valid although the
findings of the panel data regression ranked gold price as the second most significant
independent variable during the Chinese stock market crash.

According to Workman (2019), in 2018, China has exported US$2.294 trillion worth
of goods, and has become the world’s largest exporter by value. Not only that, China has also
become the world’s second largest FDI outflow country. With such huge trading influence
over the world market, the Chinese stock market crisis would have definitely caused a
spillover effect towards the global economy, especially those countries with strong financial
integration with China.

A study conducted by Laurens (2019) revealed that when a country is experiencing a

financial crisis, its FDI outflow would significantly increase during the period.

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 Figure 12
China’s net outflows of FDI, in USD
Source: The World Bank

As seen on the figure above, the FDI outflows experience a sharp increase during the
2015-16 Chinese stock market crisis and has peaked in 2016, just before the crisis subsided.
While capital funds are flowing out of China during the crisis, Malaysia has successfully
captured a portion of China’s capital fund outflow. During this period, Malaysia’s FDI inflow
has raised from (Department of Statistics Malaysia, 2016). The surge in FDI inflow into
Malaysia during this period has clearly proved that the impact of FDI inflow into Malaysia
on the value of derivative assets is greater than the impact of gold price when China is
undergoing a financial crisis.

In this paper, banks’ performance is measured by the efficiency ratio, which is the
non-interest expense divided by net income. With the optimal ratio of 0.5 in place, the lower
the ratio, the better than banks’ performance. Throughout the 2010-2017 period, Public Bank
Berhad has achieved a ratio of 0.3 which is the closest to the ideal ratio, ranking number one
in being the most efficient bank among other selected banks. On the other hand, OCBC Al-
Amin was ranked last in terms of performance. This is because OCBC Al-Amin is a
relatively new establishment as compared with the other two islamic banks. Therefore,
OCBC Al-Amin incurred higher expenses to develop new financial facilities and open more
branches in various locations.To sum up, the longer the bank has been established, the lower
its operational expenses.

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 Moving on, over the period of Chinese stock market crisis, Public Bank’s number one
rank in terms of performance remained unshaken. Nonetheless, the banks with worst
performance during this period has been replaced by RHB Bank Berhad. This explained by
RHB may have strong investment ties with China. It is also observed that RHB Islamic and
OCBC Al-Amin have both performed during the slump.

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