Religious barriers can prevent Muslims from accessing traditional microfinance services, especially microloans. Firstly, because of the prohibition of usury to give and receive interest-bearing loans which are often claimed to violate ethical principles and secondly, sharia law specifically encourages the sharing of risks between lenders and borrowers under the principle of profit sharing. In contrast, traditional microcredit contracts are deliberately designed to give the microfinance institution a fixed return on each contract and for the borrower to assume the risk of uncertain returns [1]. This triggers a huge demand for Muslim-friendly financing, so that somehow, they can still access fair and sharia-compliant financing.

On the other hand, MFIs are social entities with dual objectives (social and financial performance). Both Islamic MFIs and traditional MFIs face two issues; first, they provide a number of financial services to the poor and second, they need to cover their expenses to maintain business continuity. If in the past MFIs relied on donations and grants, now the funding options have expanded. The issue of shifting missions and commercialization paradigms encourages MFIs to transform into profit-oriented institutions [2]. Sustainability missions highlight the financial viability and capacity of the MFI to operate smoothly, while social performance refers to the MFI's ability to reach the poorest clients on an adequate basis [3]. Therefore, the configuration of the capital structure is important to maximize these two goals.

Investigation into optimal capital structure has been an important cornerstone of research since the classic work of Modigliani and Miller in 1958 and 1963. Modigliani and Miller highlighted the use of as much debt as possible by a company so as to maximize its value. The development of the next capital structure theory was pioneered by Kraus and Litzenberger in 1973, that the optimal capital structure is achieved when the benefits and marginal costs of debt are equal. Jensen and Meckling in 1976 introduced agency costs arising from conflicts between agents and principals. Meanwhile, Myers in 1977 put forward the problem of underinvestment, that shareholders may not be able to enjoy investment returns because they were taken over by bondholders. Furthermore, Myers and Myers and Majluf in 1984 proposed pecking order theory. This theory postulates that because a company's internal funds are not valued in the market and are lower cost than debt and equity, internal financing should be the first funding option. However, if internal funds are insufficient, debt should be the second and, finally, equity option. However, there is still a lack of literature, especially regarding the capital structure of Islamic microfinance institutions. Sharia compliance is considered to play an important role in determining the company's financing options.

LKMS funding sources can come from its members, such as cooperatives, profit sharing from financing customers and Islamic social financial instruments (zakat, infaq, alms and endowments). Different MFIs may adopt different financing contracts. However, murabahah, mudharabah and musyarakah instruments are considered the most popular financing [4]. Under a murabaha scheme, investors supply real assets purchased in non-cash by clients with a mark-up. While the penetration of Islamic finance among Muslims is increasing, these contracts are criticized for imposing interest rates and ignoring profit-sharing motives. Murabaha is also considered too rigid to serve a diverse population. As an alternative, equity contracts such as mudharabah and musyarakah are starting to be explored. The application of the two contracts aims to optimize the entrepreneurial skills and good morale of the customer without any guarantees. This mechanism seems to be in line with the characteristics of MFIs which provide capital without collateral for the poor [5].

Meanwhile, Indonesia has the most well-known Islamic financial services institutions and Islamic finance clients under one umbrella that reflect special characteristics, such as Islamic rural banks and informal MFIs [6]. Apart from the fact that Indonesia is a country with the largest Muslim population in the world, the presence of LKMS in Indonesia is important for two reasons. First, because of the large demand for Islamic microfinance services and second, Islamic funds help overcome capital shortages in micro, small and medium enterprises significantly [7]. LKMS are considered to play an important role given the minimal involvement of Islamic banks in micro business funding and as initiatives towards socio-economic justice. In this case, Islamic rural banks (BPRS) were formed to serve poor customers who are excluded from the bank [8].

The increasing role of the BPRS is marked by the massive financing provided. Graph 1. shows an increase in BPRS financing by 54.4%, from the previous value of 7.7 trillion rupiah to 11.9 trillion rupiah. If observed, the contribution of murabahah contracts dominates the total financing of BPRS for the last five years, although the trend is relatively decreasing. The high growth of profit sharing at BPRS is proof that the existence of the institution will continue to be needed, so that the issue of financial sustainability is interesting to study. Meanwhile, the fact that BPRS capital structure decisions are determined by management preferences, leads researchers to the assumption that BPRS may expose debt.

Figure 1: The contribution of the BPRS financing component during 2017-2021

Source: Financial Services Authority (processed).

This study aims to investigate the effect of capital structure decisions on the financial sustainability of Islamic rural banks (BPRS) in Indonesia through the contribution of non-profit sharing financing (murabaha). This study highlights two important questions:

(1) what is the proportion of murabahah financing in the BPRS capital structure?

(2) does the capital structure affect financial sustainability?

Researchers exposed data from Sharia Banking Statistics, the Indonesian Financial Services Authority during 2014-2022 using a two-stage regression technique which is also an element of the novelty of the study. This study contributes to the literature, especially regarding the structure of BPRS financing in terms of trade-off theory and the issue of financial sustainability. This study is expected to be useful for managers regarding optimal funding options that affect profitability and financial sustainability and for micro-entrepreneurs, regarding alternative partnerships through Islamic finance contracts. This study is also expected to provide input to regulators regarding the engineering of modern Islamic financial products that suit the needs of society.

Theory Review

The trade-off theory popularized by Kraus and Litzenberger in 1973 states that a company's capital structure must refer to the trade-off between tax interest benefits and bankruptcy costs. This theory postulates that optimal capital structure is achieved when the marginal benefits and costs of debt are balanced. As a result, lower costs encourage companies to optimize leverage [9]. Some researchers [10-15] claim that sustainable companies expose more debt, thus impacting on high profitability. Interestingly, similar findings also occur in the context of Islamic finance, where debt is represented by non-profit sharing contracts (murabaha). Miah and Suzuki [16] confirm that 90% of Islamic bank funding in Muslim countries is concentrated in murabaha. This indicates the high preference of Islamic financial institutions for debt so that it is considered relevant to the trade-off theory.

Empirical Review

Agasha et al. [17], investigated the mediating role of the cost of capital in the relationship between capital structure and the quality of MFI credit portfolios in Uganda. This study targeted 82 MFIs and used partial least squares modeling. Managers are advised to be wary of credit recovery. Chauhan et al. [15] highlight the effect of capital structure on the social and financial performance of MFIs in India. This study adopts a panel regression model on 46 non-bank financial institutions from 2013-2014 to 2018-2019. The results show that Indian MFIs are exposed to high leverage and there is a two-way causality between capital structure and performance. Towo [18], analyzed the correlation of leverage and financial performance in SACCOS cooperatives in Tanzania. This study exposes panel data from 115 SACCOS during 2011-2014 with a fixed effect. Researchers also investigate the moderating role of board meetings on the correlation between leverage and financial performance. Leverage affects financial performance negatively and significantly. Board meetings have a positive and significant moderating effect, implying that debt triggers an agency conflict.

Hemtanon and Gan [19] investigated the determinants of profitability (ROA) and sustainability (FSS) of MFIs in Thailand. This study uses panel data regression and highlights the annual reports of 170 MFIs during 2014-2016. There are four determinants of MFI profitability, namely average loans per client, number of clients per staff, asset size and yield ratio. Li et al. [9] investigated the impact of financial sustainability on capital structure. Researchers highlight unbalanced panel data from 45 MFIs in China during 2012-2020 and use GMM. This study also highlights the mediating effect of profitability on the relationship between financial sustainability and capital structure. Independent MFIs are claimed not to depend on leverage and are able to increase profits fairly and proportionally. Profitability is an effective control tool for MFIs to expose debt. Princess et al. investigated the effect of financial sustainability on the social performance of MFIs. This study targets 6 BPRS in Indonesia during the 2012-2018 period and is analyzed using panel data regression. The results show that there is a positive correlation between financial sustainability and social performance of BPRS.

Research Conceptual Framework

The proportion of murabaha along with control variables, such as savings mobility, size, capital adequacy ratio and productivity, is thought to influence the sustainability of the BPRS, both operationally and financially. Sustainability is measured through the Operational Self-Sufficiency Ratio (OSS ratio) and the Financial Self-Sufficiency Ratio (FSS ratio). BPRS is operationally sustainable if it has an OSS ratio of ≥100%; and financially sustainable if it has an FSS ratio of ≥110% or more and vice versa (Bogan, 2012). Figure 2 shows the conceptual framework of the research.

Hypothesis Development

Non-Profit-Sharing Financing and the 'Syndrome' of Murabaha in IMFIs: Miah and Suzuki [16] capture the 'murabaha syndrome' in Islamic banks operating in the Gulf   region,   where   around   90   percent   of   total  bank financing is concentrated in murabaha and ijarah. Both instruments are considered to generate substantial income for banks and there has been no significant change in trend over the years. Similar findings were also claimed by Belkhaoui et al. [20], that murabaha affects profitability and simultaneously increases the ratio of capitalization and cost efficiency of Islamic banks in GCC countries. On the other hand, in the Indonesian context, Farrar and Uddin [7] found that murabaha contributed the largest portion to the BPRS and BMT financing structure. Based on this description, the hypothesis is formulated:

H1: The contribution of non-profit sharing financing (murabaha) affects the capital structure (DER).

Figure 2: Research Conceptual Framework

Source: Researcher design (2023)

BPRS Capital Structure and Financial Sustainability

In the context of traditional MFIs, Islam and Nasreen (2018) investigated 38 MFIs operating in Bangladesh during 2003-2017 through fixed and random effects and found that the majority of MFIs were exposed to high leverage and most of this debt was in loans and savings. Bibi et al. [14] examined the impact of capital structure on MFI performance in Asia and found that debt increases the financial sustainability of MFIs. Chauhan et al. [15] investigated the effect of capital structure on the performance (social and financial) of MFIs in India by observing 46 NBFIs from 2013-2014 to 2018-2019. The results show that Indian MFIs are exposed to high leverage and have a two-way causality between capital structure and performance. Based on this description, the hypothesis is formulated:

H2: The capital structure influences the financial sustainability of the BPRS.

This study is based on explanatory quantitative and highlights 167 BPRS in Indonesia with time-series based data and processes combined BPRS financial reports, from the Financial Services Authority (OJK) Sharia Banking Statistics from January 2014 to July 2022 and processed through Microsoft Excel and STATA. The independent variable in this study is capital structure (DER), followed by financial sustainability as the dependent variable and murabaha contract contribution as the intermediary variable. Several control variables such as savings mobility, size, CAR ratio and staff productivity ratio were also identified. Researchers conducted descriptive and inferential analyzes to investigate the effect of capital structure on the financial sustainability of BPRS through the contribution of murabaha financing.

The Effect of the Contribution of Murabahah Financing on the Capital Structure Decisions of BPRS in Indonesia during 2014-2022

Table 1 below presents the results of the first stage of regression, namely the effect of the proportion of murabahah financing on the capital structure ratio (DER).

Based on Table 1, the proportion of murabahah has a positive and significant impact on the BPRS capital structure. This implies that the more intensely the BPRS is involved in murabaha financing, the more debt is in the BPRS' capital structure. This supports the trade-off theory and is in line with several researchers [10,11,15]. Savings mobility also has a positive and significant impact on capital structure. This shows that BPRS has a high dependence on savings and is in line with Islam and Nasreen [10]. The size variable also has a positive and significant effect on capital structure, which implies that large BPRS have stable and well-established financing portfolios. A positive and significant correlation was also found in staff productivity, implying that promotion and training activities had an impact on efficient staff performance and increased BPRS leverage. This is in line with several researchers [19,21]. On the other hand, the CAR variable has a negative and significant impact on capital structure. CAR as an indicator of bank health shows that a “healthy” BPRS operates with little debt. This is in line with several researchers [2,3,9,19,22].

Effect of Capital Structure Decisions on BPRS Operational Sustainability

Table 2 below presents the results of the second stage of regression, namely the effect of the capital structure ratio (DER) on operational sustainability (OSS).

Based on Table 2, the capital structure has a positive and significant impact on the sustainability of BPRS operations. This implies that the massive BPRS debt financing has an impact on increasing the company's operating income. This supports the trade-off theory and is in line with several researchers [12,15]. Subsequent positive and significant correlations were found in the mobility of savings and the CAR ratio, indicating that adequate savings funds and BPRS capital enhance internal stability. On the other hand, size and productivity variables have a negative and significant impact on operational sustainability. This indicates that BPRS which have few assets tend to be unsustainable. In addition, the high promotion and training activities have proven to increase the company's operating expenses.

The Effect of Capital Structure Decisions on the Financial Sustainability of the BPRS

Table 3 below presents the results of the second stage of regression, namely the effect of the capital structure ratio (DER) on financial sustainability (FSS). Based on Table 3 above, the capital structure has a positive and significant effect on the financial sustainability of the BPRS. This is interesting because the proportion of murabahah contracts has proven to increase the sustainability of BPRS both operationally and financially. Here, the DER ratio has a higher coefficient value and better significance than the OSS. This strengthens the trade-off theory, that the debt-based financing structure of BPRS increases financial sustainability and is in line with several researchers [13,14]. On the other hand, only the size variable has a negative and significant impact on the financial sustainability of the BPRS. This implies that large BPRS may not be sustainable. This evidence is in line with Hemtanon and Gan [19], that BPRS are encouraged not only to be profit-oriented, but also to maximize their social performance through grants and qardhul hasan instruments.

Table 1: First Stage Regression: The Effect of Contribution of Non-Profit Sharing Financing (Murabaha) on the Debt-to-Equity Ratio (DER)

Table 2: Second Stage Regression: Effect of Debt to Equity Ratio on OSS

Table 3: Second Stage Regression: Effect of Debt to Equity Ratio on FSS

BPRS have a preference for debt-based financing - with the proportion of murabahah contracts amounting to 77.90% of total financing and the high level of debt financing has proven to increase the sustainability of the company, both operationally and financially. This research supports the trade-off theory and is in line with several researchers [10-15]. BPRS are considered to be highly profit-oriented and tend to target relatively wealthy customers. However, BPRS have an average OSS ratio of 1.04 (>100%) and FSS of 0.87 (<110%), which proves that BPRS is operationally sustainable, but not financially sustainable. This encourages BPRS to look for other revenue channels and diversify their revenues. As sharia MFIs, BPRS are advised to explore production sharing contracts (mudharabah and musyarakah).

Research Limitations

The lack of available supporting data and empirical literature which is quite rare for research on this topic. Future researchers can expose other sources that are more adequate and use more varied indicators.

The high contribution of murabaha financing to BPRS confirms the preference for debt-based institutional financing. Furthermore, the capital structure has a positive and significant effect on the sustainability of BPRS both operationally and financially. Meanwhile, BPRS Indonesia proved to be operationally sustainable and financially unsustainable.

Recommendation

BPRS are advised to focus on their main activities to channel financing and diversify assets to obtain maximum profits.

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