ICOQSIA 2010, 2 – 4 November, Penang, Malaysia. Working Paper in Islamic Economics and Finance No. 1009 Disclosure, Cost Of Capital And Islamic Banks Performance: A Simultaneous Equations Approach 1 Nurul Huda Abdul Majid 1 , Abdul Ghafar Ismail 2 1 College of Business Universiti Utara Malaysia Sintok 06010 Kedah, Malaysia 2 Islamic Economics and Finance Research Group School of Economics Universiti Kebangsaan Malaysia Bangi, 43600 Selangor D.E., Malaysia 1 nurul@uum.edu.my, 2 agibab@ukm.my Abstract: The topic of market discipline introduced in BASEL II in 1999 has received considerable interest lately. Among others, disclosure and the capital requirements of banks greatly affects the way banks are expected to be performed. The debate on bank capital and increase disclosure arises as one approach for market discipline. This study attempts to test performance and disclosure simultaneously in exploring the relation between disclosure and performance. Using ten samples of full-fledged Islamic banks and Islamic banking windows over the period between years 2001 to 2006, this study found that performance and disclosure have interdependent relationship. The results may provide additional information in which the level of disclosure can be used to indicate the likelihood of Islamic banks to be performed and vise versa. Keywords: Accounting for Islamic Financial Institutions, Disclosure, Cost of capital, Simultaneous equation method. 1 INTRODUCTION A firm can be described as an outcome of a relationship between two different parties, a principal and an agent. This relationship (or known as agency relationship) creates a contract when principal provides equity capital and the agent manages the firm on the principal’s behalf. The separations of ownership and control in such equity type of contract suggest the needs of monitoring to mitigate agency problems (Jensen and Meckling, 1976). Therefore, to satisfy the contract and enhance agency relationship, information is needed. Disclosure of information is very much related. Any favorable information regarding the expected return disclosed might affect shareholders and potential investors. For example investment decisions to acquire shares in that particular firms. Indirectly, firms value is increased and such disclosure is important for this type of contract. In structuring the contract, firms have choices whether to choose more or less capital and the composition of capital for each type of contract. Typically. firms capital structure consists of equity and debt contract. The equity contract involves cost of equity while for debt contract, cost of debt is incurred. Cost of capital is used to measure 1 We are being benefited from the research grant UKM-OUP-EP-16/2007 and thanks to Wan Hakimah Wan Ibrahim.for research assistance 2 Professor of banking and financial economics, Universiti Kebangsaan Malaysia. Research Center for Islamic Economics and Finance Universiti Kebangsaan Malaysia Bangi 43600, Selangor, Malaysia Fax: +603-89215789 http://www.ekonis-ukm.my E-mail: ekonis@ukm.my