1. Introduction

The banking industry is considered among the most risky of industries. It is difficult to imagine another sector of the economy where as many risks are managed jointly as in the banking industry (Cebenoyan and Strahan, 2004). Due to higher risk exposures, banking supervisors require banks to set aside what is called regulatory capital. The regulatory capital is built from capital adequacy ratio (CAR). The determination of CAR considers credit risk, market risk and operational risks that exist in the banks’ balance sheet.

Due to the provision above, banks are required to hold higher amounts of capital if they intend to hold more risky assets. The choice of the capital structure, whether to rely more on equity capital or debt capital; which is better known as leverage, depends on banks’ objectives in maximizing profit to enhance shareholders values. Nevertheless, banks will be exposed to higher leverage if they hold less capital, in particular equity capital. This situation may lead the banks to have higher insolvency risk. The last financial crisis has shown how higher leverage created problems for the global financial economy. This is the reason why Belhaj (2010) stated that credit crunch can be explained through banks’ capital structure. This is because capital structure is able to explicate a healthy functioning of companies in free market economies (Ibrahimo and Barros, 2010).

The issue of banks’ capital structure and leverage is also surrounding the development of the Islamic banking industry. Interestingly, discussion on leverage in Islamic banks is not only focused on the original source of leverage which is the debt, but also to the “other sources” of leverage that only exist in the banking structure: the profit-sharing investment account (PSIA). PSIA is a profit-sharing loss-bearing account in the liability side of an Islamic bank, as a consequence of the Mudharabah agreement between Investment Account Holders (IAH) and the bank. In this arrangement, banks act as fund manager (Mudarib) on behalf of IAH in managing investment made from PSIA funds. The Mudarib and IAH as owner of the fund (Rabbul Maal) will share profits generate from the investment. In contrast, losses should be borne solely by the IAH, unless there is clear evidence that the losses are due to misconduct and negligence of the banks as mudarib.