CHAPTER 1: INTRODUCTION

1.1 Overview of Study

1.1.1 Islamic banking

Islamic banking is a banking activity based on Islamic principles, which do not allow the

paying and receiving of interest (riba) and promotes profit sharing in the conduct of

banking business.

The most important difference between Islamic and conventional banking is the

prohibition of interest in Islamic banking. Islamic banking activity must comply with

Shariah principles and avoid prohibited activities such as gharar (excessive uncertainty).

Today, Islamic banking all over the world is managing huge funds. Its clientele are

not confined to Muslim countries but are spread over Europe, United States of

America and the Far East.

Islamic banking continues to grow at a rapid pace because of its value-orientated

ethos that enables it to draw finances from both Muslims and non-Muslims alike.

Islamic bankers, keeping pace with sophisticated techniques and latest developments

have evolved investment instruments that are not only profitable but are also ethically

motivated.

In Malaysia, the central bank, i.e Bank Negara Malaysia (BNM), regulates the law

governing the banking system in Malaysia. The Islamic banking system in Malaysia is

1
subject to dual regulations, namely the regulations of the Islamic banking Act 1985

and the Shariah Council on the other hand, and the regulations imposed by BNM and

the Banking and Financial Institutions Act (BAFIA) 1989, on the other (Samad,

1999). The recent survey states that there are more than 160 Islamic financial institutions

existing around the world (Sufian, 2007). As at January 2008, there are 12 full-fledged

Islamic banks in Malaysia as stated by Bank Negara Malaysia.

The first Islamic bank was established in Malaysia in 1983. In 1993, commercial banks,

merchant banks and finance companies were allowed to offer Islamic banking products

and services under the Islamic Banking Scheme (IBS banks). The IBS banks are required

to ensure that the funds and activities of the Islamic banking transactions are separated

from the conventional banking business.

The objectives of the Islamic financial system are based on Islamic Law, Shariah.

Ideally, the objectives are threefold. The first objective is to offer Muslims an

alternative to conventional banking and this alternative is interest-free banking. The

second is to achieve equitable distribution of income and wealth. The Islamic

financial system is to be treated as an important vehicle to transfer funds from the

surplus to the deficit units. This is done to ensure the equitable allocation of capital to

sectors which would yield the best returns to the owners of capital, thereby

contributing towards the over all growth and expansion of an economy.

Another important objective of the Islamic financial system is to ensure that the

surplus fund be attracted for worth while investments in accordance with the owners

preference in terms of the extent of risk involvement, rate of return, as well as the

period of investment. Still another objective of the Islamic financial system is to help

2
the fund owners to find sufficient opportunities to invest for the short term. Since it is

contrary to Shariah principles to hoard wealth, it is necessary for the wealth owners to

invest their funds in projects of either short-term or long-term nature. Lastly, the

Islamic financial system is aimed to promote economic development. It is viewed by

Muslims as an alternative to the existing interest-based financial system and

institutions and by non-Muslims as a healthy development that adds a variety

rendering financial system as highly competitive.

1.1.2 Growth of Islamic Banks

In recent times, Islamic banking and financing services have increased phenomenally

around the world. Islamic bank, as defined by Islamic Development Bank (IDB), is a

deposit-taking banking institution whose scope of activities includes all currently

known banking activities, excluding borrowing and lending on the basis of interest.

The practice of Islamic banking as it has developed during the last 30 years has four

main manifestations:

(a) banks and financial institutions in those countries where the promotion of

an Islamic financial system is receiving active government support;

(b) Islamic banks and financial institutions in the private corporate sector

working in a mixed environment;

(c) Islamic banking practices by some conventional commercial banks and

non-bank financial institutions;

(d) multinational financial institutions working on Shariah principles.

3
Islamic banking is in a rapidly growing stage as a feasible alternative to conventional

banking. By early 2003, there were at least 176 Islamic banks around the world,

handling over $147 billion dollars (Ghannadian and Goswami, 2004).

The most important development in the history of Islamic banking took place with the

establishment of the Islamic Development Bank (IDB) in 1975. The IDB was

established as an international financial institution in pursuance of the declaration of

intent issued by a conference of finance ministers of Islamic countries held in Jeddah,

Saudi Arabia, in December 1973 and it started functioning on 20 October 1975.

The present membership of the IDB consists of 56 countries. The purpose of the IDB

is to foster the economic development and social progress of member countries and

Muslim communities individually as well as jointly in accordance with the principles

of Shari'ah i.e., Islamic Law.

The functions of the IDB are to participate in equity capital and grant loans for

productive projects and enterprises besides providing financial assistance to member

countries in other forms for economic and social development. IDB is also required to

establish and operate special funds for specific purposes including a fund for

assistance to Muslim communities in non-member countries, in addition to setting up

trust funds. It is authorized to accept deposits and to mobilize financial resources

through Shari'ah compatible modes. It is also charged with the responsibility of

assisting in the promotion of foreign trade especially in capital goods, among member

countries; providing technical assistance to member countries; and extending training

4
facilities for personnel engaged in development activities in Muslim countries to

conform to the Shari'ah.

The period between 1975 and 1990 was the most important period in the history of

development of Islamic financial industry. During this period, it matured into a viable

alternative model of financial intermediation. It won respect and credibility in terms

of both theoretical developments and practical experiences. On the other hand, several

financial products compatible with the Shariah were developed and, on the other

hand, Islamic banks showed good results while using these products. The period was

not only marked by the establishment of a large number of Islamic financial

institutions in the private corporate sector under different socio-economic conditions,

but also witnessed the expression of intent from three countries Pakistan, Iran and

Sudan gradually to eliminate interest from their entire economies and substitute it

with a complete banking system based on Islamic principles. Several practical steps

were also taken in these countries towards achieving that objective. Even more

important was the fact that several multinational banks started offering Islamic

financial products. That was a clear recognition of the viability of the new model and

its acceptance by international players. The International Monetary Fund (IMF) and

the World Bank also recognized Islamic financial products as a genuine means of

financial intermediation and produced papers to that effect.

1.1.3 Performance of Islamic banks

Islamic banks operate in over sixty countries, though mostly concentrated in the

Middle East and Asia (Zaman and Movassaghi, 2001). In most of these countries, the

5
banking system is dominated by conventional banking institutions with Islamic banks

operating alongside. However, Pakistan, Sudan and Iran are three countries which

have converted the entire banking system to full Islamization banking system.

Saudi Arabia is the largest market for Islamic finance in terms of size. The largest

bank in the world, Al-Rajhi Banking and Investment Corporation, is based in Saudi

Arabia. The bank had $15.8 billion in assets at the end of 2002. It can be seen that the

bulk of the Islamic banking activity is concentrated in the Middle East, especially

GCC countries. This region accounts for 85 per cent of the total assets of Islamic

banks (Iqbal and Molyneux, 2005).

The evaluation of performance of banks is made using some widely used indicators of

measuring banking performance, namely financial ratios such as return on assets

(ROA), return on equity (ROE), net interest margin (NIM) and cost to income ratio

(COSR).

When compared to conventional banks, Islamic banks as a group outperformed the

former in almost all areas and in almost all years. Most studies conclude that they

usually show better results than conventional banks. The evaluation of the

performance of Islamic banks through a number of key ratios yields fairly satisfactory

results. In general, Islamic banks are well-capitalized, profitable and stable (Iqbal and

Molyneux, 2005).

6
1.1.4 Bank Profitability

While there is abundance of literature on performance studies, these studies are

confined to conventional banks. Up to this date, there has been little research on the

profitability of Islamic banks.

Bank profitability is defined by Rose (2002) as the net after-tax income or net

earnings of a bank (usually divided by a measure of bank size).

There are several ratios that are typically used to measure the profitability of banks.

The two most often used are the rate of return on assets (ROA) and the rate of return

on equity (ROE).

In general, a number of financial ratios are usually used to assess the performance of

banks. The primary method of evaluating internal performance is by analyzing

accounting data. Financial ratios usually provide a broader understanding of the

banks financial condition since they are constructed from accounting data contained

on the banks balance sheet and financial statement.

In general, the findings of conventional banking research have indicated that internal

and external determinants of bank profitability are important, and contribute

significantly towards a banks profitability. Therefore, re-examination is needed to

evaluate their suitability and applicability in an Islamic banking context since both

banking systems have different financial concept and operations. This study intends to

7
meet this objective and to determine the internal and external variables that control

Islamic banks profitability.

1.2 Objectives of the Study

The objective of this study is divided into two parts:

Overall objective:

This study is aimed to examine the determinants that influence the profitability of

Islamic banks from 2002 to 2007.

Specific objectives:

1. To determine the bank characteristic and macroeconomic environment

factors that may influence the profitability of Islamic banks.

2. To examine the impact of bank-specific determinants on Islamic bank

profitability in 2002 to 2007.

3. To examine the impact of macroeconomics environment variables on

Islamic bank profitability, such as GDP growth and inflation.

4. To investigate whether internal and external variables that influence the

profitability of conventional banks have similar impact on Islamic banks.

8
1.3 Research Questions:

This paper intends to provide answers to these questions:

1. What are the factors/variables that influence the profitability of Islamic

banks in the world?

2. What is the impact of bank-specific determinants on Islamic bank

profitability in 2002-2007?

3. How do macroeconomic variables such as GDP growth and inflation affect

the profitability of Islamic banks?

4. Do the internal and external variables that influence the probability of

conventional banks have similar impact on Islamic banks?

1.4 Significance of Study

The finding from this study is beneficial to many parties such as the government,

academician, the banks, the customers, the students, the investors and the

shareholders. The study would also contribute to the more understanding of the

factors that influence Islamic banks performance. This study of comparison is useful

in providing valuable information to relevant parties, such as bank customers, bank

management and bank regulators in constructing an efficient management policy

decision for Islamic banks to gain higher profits. This paper also contributes to the

research on the relationship between Islamic banks performance and Islamic

financial development as a whole.

9
In the last four decades, many studies have been conducted to investigate the

profitability determinants of conventional banks. Only a handful of researches have

been conducted to determine the profitability of Islamic banks. Hence, this study

provides a significant additional evidence to postulate some profitability theories

related to Islamic banking.

Extending the previous work in Islamic banking performance, this paper investigates

the strength of influence between both internal and external variables and the

profitability of Islamic banks using multiple regression methodology. By studying the

connection between Islamic banks performance and the profitability indicators, this

paper contributes to the on-going discussion on the effects of bank-characteristics and

macroeconomics factors on the performance of Islamic banking sector.

1.5 Organization of the Study

This report is divided into five chapters. Chapter 1 provides some background on

Islamic banking, specifies the objectives and purpose of this study, as well as the

significance and benefits gained from this research.

Chapter 2 reviews the related studies with respect to the Islamic banking industry as

well as conventional banks profitability evaluation. The literature review is done by

comparing past studies in terms of its sample, data collection, methodology, variables

used and results obtained. Hypotheses are developed in this section, and the possible

links between dependent and the independent variables are discussed.

10
Chapter 3 describes the data, identifies the sources and explains the methodology

which is employed in this study. This chapter also defines and highlights the

profitability measures, internal and external variables used in this study.

Chapter 4 presents the empirical results and the interpretation of the analyses,

discusses the hypotheses tested and elaborates on the findings obtained from the

regressions.

Chapter 5 summarizes the main findings and gives the conclusion to this research

with a discussion of implications, limitations of this study and suggestions for future

research.

11
CHAPTER 2: LITERATURE REVIEW

In this chapter, a review of the relevant literature is presented, distinguishing between

studies that have examined the determinants of bank profitability and studies that have

focused on the performance of Islamic banks. This distinction is drawn here to

highlight, in the case of the former, the underlying factors determining domestic

banking sector profitability, and in the case of the latter, evidence relating to profit

performance and efficiency of Islamic banks.

2.1 Determinants of bank profitability

In the last four decades, many studies have been conducted to investigate the

profitability of conventional banks. Among the recent studies are by Peters et al.

(2004), Kosmidou et al. (2006), Mamatzakis and Remoundos (2003), Athanasoglou et

al. (2008), Pasiouras and Kosmidou (2007), Naceur (2003), Heffernan and Fu (2008)

and Goddard et al. (2004). Only a handful of researches have been conducted to

determine the profitability of Islamic banks, for example Haron and Wan (2004),

Hassan and Bashir (2003) and Haron (1996).

Peters et al. (2004) analyzed the performance and balance-sheet characteristics of

banks in post-war Lebanon for the years 1993 to 2000 and for a control group of

banks from five other countries in the Middle East for the years 1995 through 1999.

The number of Lebanese banks included in their sample varies by year and ranges

from 66 to 54 banks per year. They compared their sample banks with a control group

of 52 banks from five countries, including United Arab Emirates (18 banks), Saudi

12
Arabia (10), Kuwait (8), Bahrain (9), and Oman (7). They employed the accounting

return-on-equity (ROE) model to investigate profitability and leverage. The

components of bank profitability are analyzed by focusing on net interest margin

(NIM). This study employed regression models that relate bank profitability ratios to

various explanatory variables. This study tests the relationships between bank

profitability and size, asset portfolio composition, off-balance sheet items, ownership

by a foreign bank, and the ratio of employment to assets. The results suggest that

cross-sectional variation among banks play a major role in explaining ROA. Their

models show a strong association between economic growth and bank profitability,

whether measured by ROE or ROA. They found that Lebanese banks are profitable,

but not as profitable as a control group of banks from five other countries located in

the Middle East.

Kosmidou et al. (2006) investigated the impact of bank-specific characteristics,

macroeconomic conditions and financial market structure on UK owned commercial

banks profits, measured by return on average assets (ROAA) and net interest margins

(NIM). An unbalanced panel data set of 224 observations, covering the period 1995-

2002, provided the basis for the econometric analysis. They relied on two commonly

used measures of profit performance namely return on assets (ROAA) and net interest

margin (NIM). The five measures used as internal determinants of performance are:

cost to income ratio as an indicator of efficiency in expenses management; ratio of

liquid assets to customer and short term ratio of loan loss reserves to gross loans as an

indicator of banks asset quality; ratio of equity to total assets representing capital

strength; and the total assets of a bank representing its size. Turning to external

determinants, four measures were considered, two of which represent the influence of

13
macroeconomic conditions and the other two of financial market structure. The results

showed that capital strength, represented by the equity to assets ratio, is the main

determinant of UK banks profits. The other significant determinants are cost-to-

income ratio and bank size, both of which impact negatively on bank profits.

Mamatzakis and Remoundos (2003) examined the determinants of the performance of

Greek commercial banks from 1989 to 2000. They measured the profitability of the

commercial banks using the ratios of return on assets (ROA) and return on equity

(ROE). They considered internal factors, like management policy decisions and

external factors, like economic environment to explain the profitability of the banks.

The results suggested that the variables related to management decisions assert a

major impact on the profitability of Greek commercial banks.

Athanasoglou et al. (2008) examined the effect of bank-specific, industry-specific and

macroeconomic determinants of bank profitability of Greek commercial banks and

covers the period 1985-2001. They employed an empirical framework that

incorporates the traditional structure-conduct-performance (SCP) hypothesis. The

profitability variable is presented by two alternative measures: the ratio of profits to

assets, i.e. the return on assets (ROA) and the profits to equity ratio, i.e. the return on

equity (ROE). Five bank-specific factors used to test the correlation with bank

profitability. Capital variable which is proxied by equity to assets ratio, and

productivity growth variable produced a positive and significant relationship with

profitability. Next, credit risk and operating expenses management were found to be

negatively significant. Lastly, the effect of bank size on profitability was found to be

not important. Two industry-specific profitability determinants utilized namely

14
ownership and concentration were found to be insignificant in affecting the

profitability. Macroeconomic control variables, such as inflation and cyclical output,

clearly affect the performance of the banking sector. In conclusion, their findings

indicated that all bank-specific determinants, with the exception of size, affect bank

profitability significantly in the anticipated way.

Goddard et al. (2004) investigated the profitability of European banks during the

1990s, using pooled cross-sectional, time-series and dynamic panel models. Models

for the determinants of profitability incorporate size, diversification, risk and

ownership type, as well as dynamic effects. Accounts data of 665 banks from six

European countries were downloaded from BankScope. They concluded that the

relationship between capital-assets ratio and profitability is positive.

Olson and Zoubi (2004) in their paper, tried to determine whether Islamic and

conventional banks in the GCC region are distinguishable from one another on the

basis of financial characteristics alone. They collected 237 observations, or bank-

years of data, for 141 conventional and 96 Islamic banks operating in the GCC during

the period 2000-2005. They input 26 financial ratios into logit, neural network, and k-

means nearest neighbour classification models to determine whether researchers or

regulators could use these ratios to correctly categorize a bank as Islamic or

conventional. These 26 financial ratios fall into five general categories: profitability,

efficiency, asset quality, liquidity and risk. The empirical results of this study

indicated that measures of bank characteristics are good discriminators between

Islamic and conventional banks in the GCC region. An initial glance at the data

reveals that most accounting ratios are similar for Islamic and conventional banks.

15
Nevertheless, some financial characteristics of Islamic banks are different from those

of conventional banks. Results from their classification models implied that the

operational characteristics of the two types of banks may be different. Islamic banks

are more profitable than conventional banks, but probably not quite as efficient. They

discovered that non-linear classification techniques are able to correctly distinguish

Islamic from conventional banks in out-of-sample tests at about a 92% success rate.

Pasiouras and Kosmidou (2007) examined how banks specific characteristics and the

overall banking environment affect the profitability of commercial domestic and

foreign banks operating in the 15 European Union countries over the period 1995-

2001. This study used return on average assets (ROAA) to evaluate banks

performance. Four bank characteristics are used as internal determinants of

performance. These are the banks total assets, the cost to income ratio, the ratio of

equity to assets, the ratio of bank loans divided by customers and short term funding

and bank size. In addition, six external determinants are used to examine the impact of

environment on banks performance. Two sets of variables have been considered in

this study, indicating macroeconomic conditions and financial structure

characteristics. The two macroeconomic variables used are gross domestic product

growth and inflation. In order to examine this study used the ratios stock market

capitalization to GDP, stock market capitalization to total assets of deposit money

banks, total assets of deposit money banks to GDP and banking industry

concentration. Their sample is a balanced panel dataset of 584 commercial banks

operating in the 15 EU countries over the period 1995-2001 consisting of 4088

observations. Banks were split according to their ownership resulting in two sub-

samples of 332 domestic and 218 foreign banks. All financial and ownership data of

16
individual banks as well as information concerning market concentration were drawn

from BankScope Database. Country and market specific data were obtained from

Euromonitor International Database which collects data from sources such as

International Monetary Funds (IMF), International financial Statistics (IFS), World

Economic Outlook/UN/National Statistics and World Bank. The results indicated that

profitability of both domestic and foreign banks is affected not only by banks

specific characteristics but also by financial market structure and macroeconomic

conditions. Capital strength and efficiency in expenses management were found to be

the main determinants of ROAA in all cases as the relatively high significant

coefficients of the equity to assets and cost to income ratios showed. Equity to assets

was positively related to ROAA and appeared to be the most significant determinant

of profitability. The impact of the indicators of macroeconomic conditions on ROAA

is significant in all cases.

Heffernan and Fu (2008) identified the determinants of Chinese bank performance

and assessed whether recent reforms had any effect. The sample covered 76 banks

between 1999 and 2006. Most of the data used here come from BankScope. Ten bank-

specific independent variables and three macroeconomic explanatory variables were

analyzed in this study. While four dependent variables used in this study as the

performance measures of banks. They were economic value added (EVA), return on

average assets (ROAA), return on average equity (ROAE), and net interest margin

(NIM). This study employed the system GMM model to assess the determinants of

Chinese bank performance. A fixed effects panel data model is also estimated to allow

comparison of results, and as a robustness check. Among the results obtained are cost

to income ratio is negatively signed and significant to profitability. On the contrary,

17
loan loss reserve ratio (LLR) produced a positive and significant coefficient. The

results also reported that the macroeconomic variable that performed best in this study

is the real GDP growth rate, followed by the unemployment rate. From the results it is

confirmed that the system GMM model is the preferred method of estimation. The

study also looked at the question of which of four performance measures work best.

Based on diagnostics and the significance of coefficients, the results suggested the

best dependent variables are economic value added and the net interest margin, as

against ROAA or ROAE.

Kosmidou et al. (2007) examined the determinants of profits of Greek banks

operating abroad by developing an integrated model that includes a set of

determinants informed by the literature on the profitability of both multinational and

domestic banks. The basis for the economic analysis was provided by an unbalanced

panel dataset for 19 Greek bank subsidiaries operating in 11 nations, covering the

period from 1995 to 2001. This study used return of assets (ROA) as the dependent

variable. The internal bank-specific characteristics that were included represent

information about asset quality, liquidity, capital strength, expenses management,

asset quality and size. They considered three external determinants, market

concentration, stock market capitalization and market share. Among the five

multinational variables listed under this category, three are location-specific, and two

are ownership-specific. A sample of 92 observations on each variable was collected

from BankScope database and Euromonitor International database. The results

showed that the combined set of variables leads to an improvement in the overall

explanatory power of the integrated model, compared to a model estimated only with

the multinational determinants of Greek bank profitability.

18
Naceur (2003) investigated the impact of banks characteristics, financial structure

and macroeconomic indicators on banks net interest margins and profitability in the

Tunisian banking industry for the 1980-2000 period. Two measures of performance

are used in the study: the net interest margin (NIM) and the return of assets (ROA).

Five banks characteristics indicators are used as internal determinants of

performance. They comprised the ratio of overhead to total assets, the ratio of equity

capital to total assets, the ratio of banks loans to total assets, the ratio of noninterest

bearing assets to total assets and the log of bank assets. Two macro-economic

variables were used as control variables: inflation and GDP per capita growth. First,

individual bank characteristics explain a substantial part of the within-country

variation in bank interest margins and net profitability. High net interest margin and

profitability tend to be associated with banks that hold a relatively high amount of

capital, and with large overheads. Other important internal determinants of banks

interest margins bank loans which have a positive and significant impact. The size has

mostly negative and significant coefficients on the net interest margins. This latter

result may simply reflect scale inefficiencies. Second, the paper finds that the macro-

economic indicators such inflation and growth rates have no impact on banks interest

margins and profitability. Third, turning to financial structure and its impact on banks

interest margin and profitability, he found that concentration is less beneficial to the

Tunisian commercial banks than competition. Stock market development has a

positive effect on bank profitability. This reflects the complementarities between bank

and stock market growth. The paper had found that the disintermediation of the

Tunisian financial system is favourable to the banking sector profitability.

19
Athanasoglou et al. (2006) examined the profitability behaviour of bank-specific,

industry-related and macroeconomic determinants, using an unbalanced panel dataset

of South Eastern European (SEE) credit institutions over the period 1998-2002. This

paper used annual bank level and macroeconomic data from seven SEE countries. The

bank variables are obtained from the BankScope database, the macroeconomic

variables from the IMFs International Financial Statistics (IFS) and the banking

reform index from the European Bank for Reconstruction and Development (EBRD).

Return on assets and return on equity are chosen as proxies for bank profitability.

Among the independent variables analyzed were liquidity, credit risk, capital,

operating expense management, size, concentration, inflation and economic activity.

The least squares methods of fixed effects and random effects models were applied in

the analysis. The estimation results indicate that, with the exception of liquidity, all

bank-specific determinants significantly affect bank profitability in the anticipated

way. A key result is that the effect of concentration is positive, which provides

evidence in support of the structure-conduct performance hypothesis. In contrast, a

positive relationship between banking reform and profitability was not identified,

whilst the picture regarding the macroeconomic determinants is mixed. The paper

concludes with some remarks on the practicality and implementability of the findings.

Kosmidou (2008) analyzed how the banks management decisions and policy

objectives and the overall banking environment affected the performance of banks in

terms of their return on average assets, ROAA during the period 1990-2002. An

unbalanced pooled time series dataset of 23 Greek commercial banks operating during

the above period provided the basis for the econometric analysis. Five bank

characteristics are used as internal determinants of performance. They are the cost-to-

20
income ratio, the ratio of equity to total assets, the ratio of banks loans to customer

and short-term funding, the ratio of loan loss reserves to gross loans and the banks

total assets which represent expenses management, capital adequacy, liquidity, asset

quality and size, respectively. In this study, two sets of external determinants are

examined: the macroeconomic and the financial structure indicators.

The results indicated that individual bank characteristics explain a substantial part of

the within-country variation in bank ROAA. High ROAA was found to be associated

with well-capitalized banks, with efficient expenses management (lower cost-to-

income ratio). Size was positive in all cases but statistically significant only when the

macroeconomic and financial structure variables entered the models. Referring to

macroeconomic and financial structure indicators, GDP growth has a significant and

positive impact on ROAA, while inflation has a significant negative impact. The

money supply growth has no significant impact on profits. The financial industry

structure indicators, banks assets to GDP, market capitalization to banks assets and

concentration are all statistical significant and negatively related to ROAA. Table 2.1

below illustrates the profitability ratios for the top banks in the world. The ratios

shown are the two most common profitability ratios used, which are return on assets

(ROA) and return on equity (ROE).

Table 2.1: Profitability ratios for the top 1,000 banks in the world (1990-2002)

Year ROA (%) ROE (%)

Average (1990-1996) 1.0 15.7

Average (1996-2002) 1.1 14.4

Average (1990-2002) 1.0 14.9

Source: Iqbal and Molyneux (2005)

21
Studies on determinants of Islamic bank profitability have focused on a panel of

countries (for example Haron and Wan, 2004; Hassan and Bashir, 2003 and Haron,

1996). Haron and Wan (2004) investigated the strength of influence between both

internal and external variables and profitability of Islamic banks in selected countries

using time-series techniques of cointegration and error-correction mechanism. This is

the first attempt to investigate such relationship using advance time-series technique.

The data for this study are pooled time-series cross-sectional data taken from the

annual reports of Islamic banks from five countries. The sample period for this study

is from 1984 to 2002. The independent variables used in this study are divided into

two categories, namely, internal and external variables. The internal variables are

liquidity, capital structure, deposits structure, financing structure and expenditure

item. Whereas, the external variables used are market share, money supply, interest

rate, inflation and size of the bank. Three variables used as proxies for profitability

were total income as a percentage of total assets, banks portion of income as a

percentage of total assets, and net profit after taxes as a percentage of capital and

reserves. The result showed a significant long-run relationship between profitability

measures of Islamic banks and determining variables such as liquidity, deposit items,

assets structure, inflation and money supply.

Hassan and Bashir (2003) intended to characterize some financial and policy

indicators that impact the overall performance of Islamic banks. Specifically, the

purpose of study is to closely examine the relationship between profitability and the

banking characteristics, after controlling for economic and financial structure

indicators. Utilizing bank level data, this study examined the performance indicators

22
of Islamic banks in 21 countries worldwide during 1994 to 2001. The main data

source is BankScope database compiled by IBCA. A variety of internal and external

banking characteristics were used to predict profitability and efficiency. Four

measures of performance used in this study: the net non-interest margin (NIM), profit

margin, returns on assets (ROA), and returns on equity (ROE). To assess the

relationship between performance and internal bank characteristics, their analysis

utilizes several bank ratios. The set of ratios used comprises fund source management,

funds use management, leverage and liquidity ratios. The paper used regression

analysis to determine the underlying determinants of Islamic banks performance.

They concluded that Islamic banks profitability measures respond positively to the

increases in capital and negatively to loan ratios. The results also indicated the

importance of consumer and short-term funding, non-interest earning assets, and

overhead in promoting banks profits. They suggested that the regulatory tax factors

are important in the determination of bank performance. Favourable macroeconomic

environment seems to stimulate higher profits. Finally, the size of the banking system

has negative impact on the profitability except net non-interest margin.

Haron (2004) examined the effects of the factors that contribute towards the

profitability of Islamic banks. Fourteen internal variables and six external variables

were analyzed in this study. Five ratios had been selected and used as proxies for

profitability. This study found that internal factors such as liquidity, total

expenditures, funds invested in Islamic securities, and the percentage of the profit-

sharing ratio between the bank and the borrower of funds are highly correlated with

the level of total income received by the Islamic banks. Similar effects are found for

external factors such as interest rates, market share and size of the bank. Other

23
determinants such as funds deposited into current accounts, total capital and reserves,

the percentage of profit-sharing between bank and depositors, and money supply also

play a major role in influencing the profitability of Islamic banks. While interest rates,

inflation and size have significant positive impact on the profits of conventional

banks, similar results were found for Islamic banking in this study. In the case of

market share and money supply, these variables were found to have an adverse effect

on profits and these results are in contrast to the findings of earlier studies. This study

found that there was no significant variation in earnings between Islamic banks in

competitive and monopolistic markets.

Haron (1996) examined the effects of competition and some other external factors on

the profitability of Islamic banks. This study also examines whether external variables

that influence the profitability of conventional banks have similar impact on Islamic

banks. The data for this study is a pooled time series and cross-section taken from the

annual reports of fourteen Islamic banks from various Islamic countries. Four ratios

are considered relevant and were used as proxies for profitability. The independent

variables for this study are competition, regulation, market share, interest rate, money

supply, inflation and bank size. The study found that Islamic banks in competitive

market earned more than those which operate in a monopolistic market. While interest

rate, inflation and size have significant positive impact on the profits of conventional

banks, similar results were found for Islamic banks in this study. In the case of market

share and money supply, these variables were found to have an adverse effect on

profits. This study found that there was no significant variation in earnings between

Islamic banks in competitive and monopolistic markets. The results of this study

24
revealed that banks in a competitive market were better managed than their

counterpart.

In conclusion, studies that measure the influence of various factors that determine the

profitability of Islamic banks are still at the initial stage. From the literature review, it

could be observed that very limited study has been done on Islamic bank profitability.

Vast literature concentrates on profitability determinants of conventional banking.

Within the Islamic banking literature, most studies used international data. Mainly

were conducted to examine the internal and external determinants (Haron and Wan,

2004; Haron, 2004; Hassan and Bashir, 2003) and some focused on the external

factors only (Haron, 1996).

2.2 Performance of Islamic banks

Among the researchers who have studied the performance of Islamic banks are Haron

(1996), Bashir (1998), Rosly and Abu Bakar (2003), Zaman & Movassaghi (2001),

Tamanni (2002), Islam (2003), Shamsinar (2003), Hasan (2004), Samad (2004),

Ghannadian and Goswami (2004), Pratomo et al. (2006) and Sufian (2007). Most of

the studies used return on assets (ROA) and return on equity (ROE) as performance

measures.

Rosly and Abu Bakar (2003) evaluated the profitability performance of IBS banks

compared with mainstream banks in Malaysia. They selected IBS banks which began

when the Islamic banking scheme started its operation in 1992. The researcher used

data from the year 1996 till 2000. They found that Islamic banking scheme (IBS)

25
banks have recorded higher return on assets (ROA) as they are able to utilize existing

overheads carried by mainstream banks. The ratios used in this study in order to

measure bank profitability performances are as return on assets (ROA), return on

deposit (ROD), asset utilization (AU), operating efficiency ratio (OER) and net

operating margin (NOM). This study has shown that mainstream banking performed

better than IBS banks.

Kader et al. (2007) examined the performance of UAE Islamic banks for five years

from the period 2000 till 2004. In order to see how Islamic banks performed in

comparison with the conventional banks, this study uses 11 financial ratios for bank

performance, which concentrate on the profitability, liquidity, risk and solvency, and

efficiency of the banks. The study found that Islamic banks in the UAE are different

from conventional banks from the perspective of the financial performance. The UAE

Islamic banks are relatively more profitable, less liquid, less risky and more efficient

compared to the UAE conventional banks.

Tamanni (2002) analysed the performance of Islamic banking operations at 3 foreign

banks in Malaysia in order to evaluate performances of Islamic Banking Scheme

(IBS) versus its conventional counterpart at these banks. He discovered that return on

Assets (ROA) of the foreign banks IBS was considerably higher than that of their

counterparts, and this shows that the Islamic banking operations have been more

profitable than the conventional ones. On average, ROA of the IBS was more than

1.58%, while the conventional banking at large was only 0.80% during 1996-2000.

He also concluded that, Islamic banking operations at foreign banks have been

performing considerably well in 1996-2000, during and post the Asian crisis.

26
Samad (2004) examined the comparative performance of Bahrains interest-free

Islamic banks and the interest-based conventional commercial banks during the post

Gulf War period with respect to (a) profitability, (b) liquidity risk, and (c) credit risk.

Nine financial ratios are used in measuring these performances. Data of six Islamic

banks and 15 conventional banks for the period 1991-2001 are obtained from

BankScope Database. This study used the basic three financial measures: Return on

Assets (ROA), Return on Equity (ROE) and Cost to Income Ratio (COSR) to evaluate

the profitability performance of the banks. The average ROA and ROE of Islamic

banks in Bahrain are respectively, 2.22 percent and 7.1 percent. The comparison of

financial measures expressed in terms of various financial ratios indicates that there is

no major difference in profitability and liquidity between Islamic banks and

conventional banks. In addition, Islamic banks are exposed to less credit risk

compared to conventional banks. Their credit performance is superior to that of

conventional banks.

Table 2.2: Key financial ratios: Top ten banks, 2002 (%)

Region Capital to asset ratio Cost to income ratio ROE ROA

Top ten World 3.60 75.08 3.88 0.25

Top ten Asia 3.38 84.34 -14.06 -0.38

Top ten GCC 9.51 42.83 18.47 1.76

Top ten other Middle East 4.55 56.65 13.24 0.50

Top ten Europe & America 3.96 68.35 16.79 0.80

Top ten Islamic Banks 11.12 43.83 15.56 1.75

Source: Iqbal and Molyneux (2005)

27
Table 2.2 exhibits the key financial ratios such as capital to asset ratio, cost to income

ratio, return to equity and return to assets for top ten banks in 2002. Return on assets

(ROA) of the Islamic banks was considerably higher than that of their conventional

counterparts. It shows that the Islamic banking operations have been more profitable

than the conventional banking.

Bashir (1998) studied the determinants of Islamic banks performance across eight

Middle Eastern countries between 1993 and 1998. The purpose of the study is to

closely examine the relationship between banking characteristics and performance

measures in Islamic banks. He used a cross-country bank-level data of 14 Islamic

banks in 8 countries, using BankScope database. Four measures of performance used

in this study are the net non-interest margin (NIM), profitability (BTP/TA), returns on

assets (ROA), and returns on equity (ROE). Utilizing bank level data, this paper

provides summary statistics pertaining to Islamic banks sizes and profitability. Then,

he used regression analysis to determine the underlying determinants of Islamic bank

performance. Bashir found that the Islamic banks profitability measures respond

positively to the increases in capital and loan ratios. He concluded that foreign-owned

banks are more profitable than their domestic counterparts.

In 2003, Islam examined the development and performance of local and foreign banks

in some GCC economies, such as Bahrain, Oman, and Abu Dhabi and Dubai of the

UAE. The internal performance of a bank is evaluated by constructing financial ratios

from the banks balance sheet and income statements. Key financial ratios were

calculated to assess the performance of a bank. Both cross section and time series

techniques were applied to evaluate the performance of a bank. External performance

28
is measured by evaluating the banks market share, regulatory compliance, and the

public confidence. The analysis of banks internal performance by examining the

financial ratios of accounting items showed that local and foreign banks in Bahrain,

Oman, and in Abu Dhabi and Dubai have performed well over the past several years.

Domestic and foreign banks in these economies are well capitalized and the sector is

well developed with intense competition among the banks. Most banks are reaping the

benefits of modern technology, which has helped to streamline their operations and

improve their efficiency.

Shamsinar (2003) studied on the performance evaluation of Islamic banking system

pre and post 1997 Asian Financial Crisis and the comparison of the performance of

Islamic banks with the conventional banks in term of quantitative measures of

financial ratios. Data used for this study was obtained from Bank Negara Malaysia

and annual reports of Bank Islam and Maybank. She found that the Islamic banking

system in Malaysia over its 19 years of its existence (1983-2002) performed

remarkably well in terms of the total deposits and total financing.

Abdul-Majid et al. (2008) aimed to measure efficiency of banks in countries that have

Islamic banking in operation as well as relative efficiency between countries, and

focused particularly on the relative performance of Islamic banks as compared to

conventional banks. Data on 23 Islamic and 88 conventional banks from 10 countries

that operate Islamic banking were drawn from the BankScope database for the period

1996-2002 resulting in an unbalanced panel of 558 observations. This study employed

an output distance function to examine the efficiency and returns to scale of Islamic

banks relative to conventional banks in countries that have Islamic banks. The

29
resulting model enables better understanding of difference between Islamic and

conventional banks and across different countries. This study shows that country

effects play a significant part in explaining efficiency distributions between countries,

even after controlling for country-specific environment conditions, including Islamic

banking. The results provide statistically validated evidence that suggests that banks

in Iran, Malaysia, Bahrain and Bangladesh have achieved relatively high levels of

efficiency compared to other countries in the sample. In contrast, while efficiency of

banks in Jordan, Lebanon, Tunisia, and Indonesia falls into a middle category, banks

in Yemen and Sudan can be classified as highly inefficient. On average, banks in each

of the 10 sample countries exhibit moderate returns to scale. However, the average

estimated returns to scale for conventional banks are lower than those for Islamic

banks, with the exception of Malaysia and Jordan.

Samad (1999) conducted an empirical study of managerial and productive efficiencies

of the two banking systems conventional banks and the Islamic bank in Malaysia,

Bank Islam Malaysia Berhad (BIMB). He studied the relative efficiency position of

BIMB and conventional banks of Malaysia during 1992-1996. In the analysis part,

both ratio measures and ANOVA tests conducted in this study support the hypothesis

that the managerial efficiency of the conventional banks is higher than that of the

Islamic banks. A total of 8 tests have been performed to measure the productive

efficiency of the conventional banks and BIMB. All profitability indexes indicate that

profits earned by the Islamic bank either through the use of deposit or loanable funds,

or used funds are lower than the conventional banks. The result of this study reflects

weaker efficiency position of the Islamic bank compared to that of the conventional

banks.

30
Pratomo et al. (2006) attempted to prove the agency cost hypothesis of Islamic banks

in Malaysia. Data was obtained from 15 Malaysia Islamic banks annual reports from

the year 1997 till 2004. To measure bank performance, they compute the return on

equity (ROE). They used Hausman Test to analyse the result of estimated regression.

They concluded that the higher leverage or a lower equity capital ratio is associated

with higher profit efficiency. They also discovered that size of bank is negatively

correlated to banks performance.

Sufian (2007) examined the relative efficiency between the domestic and foreign

banks Islamic banking operations in Malaysia. The paper utilized the Data

Envelopment Analysis (DEA) methodology to distinguish between 3 different types

of efficiency, such as technical, pure technical and scale efficiencies. Additionally,

Sufian performed a series of parametric and non-parametric tests to examine whether

the domestic and foreign banks were drawn from the same population. Finally, he

employed Spearman Rho Rank-Order and the Parametric Pearson correlation

coefficients to investigate the association between the efficiency scores derived from

the DEA results with the traditional accounting ratios. For the empirical analysis, all

Malaysian conventional banks that offered Islamic banking window services were

incorporated in this study. Data were taken from published balance sheet information

in annual reports of each individual bank. The results from the DEA suggest that

Malaysian Islamic banks efficiency declined in year 2002 to recover slightly in years

2003 and 2004. From Spearman and Pearson correlation coefficients, he suggested

that overall efficiency is positively and significantly associated with all accounting

measures of performance. Sufian concluded that domestic Islamic banks were more

31
efficient compared to the foreign Islamic banks albeit marginally. He also found that

larger Malaysian Islamic banks tend to disburse more loans and are more efficient

compared to its smaller counterparts. He discovered that market share has a positive

and significant effect on Malaysian Islamic banks efficiency. Finally, he learned that

the more efficient banks tend to be more profitable.

Zaman and Movassaghi (2001) conducted a performance analysis on Islamic banking.

The objectives of this paper were to review the growth of Islamic banking on a global

basis and to assess its performance based on the latest financial data available. From

the result, by the end of 1996, the number of Islamic banks rose to 166 with total

assets of $137 billion. It should be pointed out that about 49 percent of all assets of

Islamic banks in the world were commanded by Middle East. This is principally

because of Iran, whose entire financial system is based on non-interest bearing

transactions and instruments. This study concluded that some of the practices and the

financial instruments used by the Islamic banks do not seem to conform to the

traditional Islamic principles.

Mokhtar et al. (2008) conducted a study to provide empirical evidence of Islamic

banks efficiency in Malaysia for the years 1997 to 2003. For analysis purpose, this

study used 288 panel data from the banks financial statements of two-fledged Islamic

banks, 20 Islamic windows and 20 conventional banks were used. This study

measured the technical and cost-efficiencies of these banks using the non-parametric

frontier method, data envelopment analysis (DEA). The findings showed that the

average efficiency of the overall Islamic banking industry has increased during the

survey period. The study also revealed that the full-fledged Islamic banks were more

32
efficient than the Islamic windows. However, the efficiency level of Islamic banking

was still less efficient than the conventional banks. On the other hand, foreign banks

were found to be more efficient than domestic banks. Finally, they revealed that the

technical and cost efficiencies of Malaysian Islamic banks could be improved further.

To conclude, studies on the performance of Islamic banks were focused on a panel of

countries for example Middle East countries (Bashir, 1998), GCC countries (Islam,

2003); Abdul-Majid et al. (2008) and single country such as Bahrain (Samad, 2004),

Malaysia (Rosly and Abu Bakar, 2003; Samad, 1999; Sufian, 2007; Mokhtar et al.,

2008), and United Arab Emirates (Kader et al., 2007). Many researches used Data

Envelopment Analysis (DEA) method to evaluate Islamic bank performance, for

instance Mokhtar et al. (2008), Sufian (2007) and many others.

2.3 Development of Hypotheses

Theoretical framework is a basic conceptual structure organized around a theory. It

defines the kinds of variables that are going to be used in the analysis. Figure 2.1

exhibits the theoretical framework for this study. Seven independent variables namely

capital, liquidity, bank risk, efficiency, GDP growth and inflation are categorized into

two types of factors, namely bank-specific or macroeconomic factors. Bank

profitability is the dependent variable and three proxies to bank profitability are used

in this study, namely return on equity (ROE), return on assets (ROA) and net non-

interest margin (NIM).

33
 Independent Variable

BANK-SPECIFIC H1, H2, H3, H4, H5

FACTORS
Dependent Variable
Capital (+) BANK
Liquidity (-)
Asset Quality (+) PROFITABILITY
Efficiency (-)
ROE
Independent Variable ROA
H6, H7 NIM
MACROECONOMIC
FACTORS
GDP growth (+)
Inflation (+)

Figure 2.1: Theoretical Framework

This paper attempts to test seven hypotheses. A hypothesis is a claim or assumption

about the value of a population parameter. It consists either of a suggested explanation

for a phenomenon or of a reasoned proposal suggesting a possible correlation between

multiple phenomena. According to Becker (1995), hypothesis testing is the process of

judging which of two contradictory statements is correct.

Internal variables:

1. Hypothesis 1: Profitability has a positive and significant relationship with

equity to asset ratio (EA).

Equity to asset ratio is a measure of capital adequacy. Athanasoglou et al. (2008)

found that the coefficient of the capital variable (EA) is highly significant and

34
positively related to profitability. Mamatzakis and Remoundos (2003) also discovered

a similar result. The ratio shows the ability of the bank to withstand losses. It is

expected that the higher the equity to assets ratio, the lower the need to external

funding and therefore the higher the profitability of the bank.

2. Hypothesis 2: Loan loss reserves ratio (LLR) has positive and significant

relationship with profitability measures.

Ratio of loan loss reserves to gross loans is a measure of banks asset quality.

Heffernan and Fu (2008) found a positive and significant coefficient on the loan loss

reserve ratio (LLR) for all the dependent variables (except ROAE) suggests loan loss

provisioning actually improved performance. With a sound quality of loans, in

accordance to the risk-return hypothesis, a high ratio could imply a positive

relationship between risk and profits.

3. Hypothesis 3: Profitability has negative significant relationship with COSR

ratio.

Cost to income ratio is used as an indicator of efficiency in expenses management.

The coefficient of cost to income ratio was found to be the most significant

determinant and negatively related to profitability by Pasiouras et al. (2007) and

Kosmidou et al. (2006). According to Kosmidou, since higher expenses normally

mean lower profits and vice versa, COSR is expected to have a negative effect on

bank profits and margins. The lower the COSR ratio, the better is the profitability

performance of a bank.

35
4. Hypothesis 4: Net loan to total asset ratio (NLA) has an inverse and

significant relationship with profitability.

Net loans to total asset ratio is a liquidity ratio. It indicates how much of the assets of

the bank is tied up in loans. This hypothesis claims that when NLA ratio is high,

profitability declines. Higher ratios may be indicative of better bank performance

because of increases in interest income. However, very high ratios could also reduce

liquidity and increase the number of marginal borrowers that default. Heffernan and

Fu (2008) found mix results for NLA. Nevertheless, Demirguc-Kunt and Huizinga

(1999) found that NLA gave a negative and significant impact on bank profitability.

5. Hypothesis 5: Profitability has an inverse and significant relationship with

liquid assets to deposit and short-term funding ratio (LIQ).

Liquid assets to deposit and short-term funding ratio is used as a proxy to liquidity.

Previous studies reported mix results for this ratio as well. For example, Heffernan

and Fu (2008) discovered that it is positively related to ROA and ROE, but it has

negative effect on NIM. This hypothesis argues that the higher the value of this ratio,

the more liquid the bank is. Liquid assets are associated with lower rates of return;

therefore this variable is expected to have a negative relationship with performance.

36
External variables:

Macroeconomic:

6. Hypothesis 6: Profitability has a positive significant relationship with GDP

growth.

The positive impact of GDP growth supports the argument of the positive association

between growth and financial sector performance, and is also confirmed by Kosmidou

(2006) and Hassan and Bashir (2003). GDP is expected to have impact on the demand

for bank loans, whereby increase in bank loans would increase the bank profitability.

7. Hypothesis 7: Profitability has a positive and significant relationship with

inflation.

Inflation was found significant and positively associated to profitability by most

studies such as Athanasoglou et al. (2008), Kosmidou et al. (2006), Pasiouras et al.

(2007) and Demirguc-Kunt and Huizinga (1999). High inflation rates are generally

associated with high loan interest rates, and therefore, high incomes. Thus, inflation is

expected to have a positive association with profitability.

37
CHAPTER 3: RESEARCH METHODOLOGY

3.1 Sample and Data

The data used for this study are from a pooled time-series cross-sectional data. The

data are taken from various countries. Sample period for this study is from 2002 to

2007. Cross-sectional data provide information on variables for a given period of

time. While time series data give information about variables over a number of

periods of time.

The data for internal variables are obtained from BankScope database which is

compiled by International Bank Credit Analysis Limited (IBCA). Using BankScope

has two advantages. Firstly, it has information for 11,000 banks, accounting for about

90% of total assets in each country. Secondly, the accounting information at the bank

level is presented in standardized formats, after adjustments for differences in

accounting and reporting standards. The data for external variables are obtained from

World Economic Outlook 2008 database, published by International Monetary Fund

(IMF).

A total of 60 Islamic banks from 18 countries were chosen in this study. The selected

banks are those which are classified as Islamic bank in BankScope database. The

Islamic banks have available data for at least one year between 2002 and 2007. This

yielded an unbalanced panel data consisting of 260 observations. However, after

eliminating cases with missing data, only 155 observations of balanced panel data are

left.

38
Ratios provided in BankScope are divided into 4 categories, namely asset quality,

capital, operations and liquidity. In this study, at least one ratio is chosen from each

category to represent the internal variables.

The data are classified as panel data because it is a combination of cross-sectional and

time series data. An advantage of using panel data is that more observations on the

explanatory variables are available. This has the effect of helping overcome the

inherent multicollinearity which probably exists between the independent variables.

Most of past researches which studied on bank profitability used panel data to

investigate the relationship between the performance measures. Haron and Wan

(2004) used pooled time-series cross-sectional data for their study, which was taken

from annual reports of Islamic banks from five countries namely Malaysia,

Bangladesh, UAE, Jordan and Bahrain. The sample period for their study was from

1984 to 2002.

Hassan and Bashir (2003) also utilized cross-country bank level data to examine the

performance indicators of Islamic banks. The data was compiled from income

statements and balance sheets of Islamic banks in 21 countries for each year from

1994 to 2001. The main source was BankScope database compiled by IBCA. Other

data sources used included International Monetary Funds International Financial

Statistics (IFS), World Development Indicators, and Global Development Finance.

39
Mamatzakis and Remoundos (2003) used panel data, since it combines time series

with cross section observations. According to them, the main advantage of using a

panel data set is that it allows the detail account of the dynamic developments of the

banking sector. The study covered the period 1989-2000 and included 17 major

commercial banks of that period.

3.2 Profitability Measures

In the banking literature, there are many profitability ratios that have been used by

researchers in measuring bank performance. To evaluate the performance of Islamic

banks, some of the measurements used are profitability, efficiency, soundness,

prudence, economy and effectiveness. This study focuses only on the profitability

aspect. There are several ratios that are typically used to measure the profitability of

banks. The two most often used are the rate of return on assets (ROA) and the rate of

return on equity (ROE) (Iqbal et al., 2005).

In this study, the ratios that have been selected and used as proxies for profitability

are:

ROA : Return on Assets

ROE : Return on Equity

NIM : Net Non-Interest Margin

Table 3.1 shows the definitions, notation and the expected effect of the explanatory

variables on bank profitability.

40
41
Return on Assets (ROA)

ROA is the ratio of a banks net after-tax income divided by its total assets (Rose,

2002). The return on assets (ROA) is a financial ratio used to measure the relationship

of profits or earnings and total assets. ROA measure assesses the profitability

performance of total assets, and could be treated as measure of financial performance

in this study. ROA reflects the bank management ability to generate profits

(Tarawneh, 2006). The return on asset primarily indicates managerial efficiency

(Rose, 1991). It indicates how efficiently the (top) management of the bank has been

able to convert the banks or institutions assets into net earnings, i.e. profits (Samad,

1999).

ROA is probably the most important single ratio in comparing the efficiency and

operating performance of banks as it indicates the return generated from the assets

financed by the bank. Average assets are being used in this study, in order to capture

any differences that occurred in assets during the fiscal year.

Return on Equity (ROE)

ROE is the ratio of a banks net after-tax income divided by its total equity capital

(Rose, 2002). The return on equity (ROE) is considered to be one of the profitability

performance ratios (Tarawneh, 2006). It indicates how effectively the management of

the enterprise (bank) is able to turn shareholders funds (i.e. equity) into net profit. It

is the rate of return flowing to the banks shareholders (Samad, 1999). The higher

ROA and ROE reflect higher managerial efficiency of the bank and vice versa.

42
Net Non-Interest Margin (NIM)

The NIM is defined as the net income accruing to the bank from non-interest activities

(including fees, service charges, foreign exchange, and direct investment) divided by

total assets. Non-interest income is growing in importance as a source of revenue for

conventional banks in the 1990s. Some of the fastest growing non-interest income

items include ATM surcharges, credit-card fees, and fees from the sale of mutual

funds and annuities. For Islamic banks, non-interest income, NIM, makes up the

lions share of total operating income and captures the banks ability to reduce the risk

of insolvency. Moreover, since the returns on Islamic banks deposits are contingent

on the outcomes of the projects that banks finance, then NIM reflects the

managements ability to generate positive returns on deposits. If banks were able to

engage in successful non-loan activities and offer new services, non-interest income

will increase overtime (Hassan and Bashir, 2003).

Rose (2002) defined noninterest margin as the amount of noninterest revenues

stemming from deposit service charges and other service fees the bank has been able

to collect (called fee income) relative to the amount of noninterest costs incurred

(including salaries and wages, repair and maintenance costs on bank facilities, and

loan-loss expenses). The higher this ratio, the cheaper the funding or the higher the

margin the bank is commanding. Higher margins and profitability are desirable as

long as the asset quality is being maintained. In the West, NIM is usually dismissed as

too narrow a measure because of the expansion into off-balance-sheet (OBS)

activities (Heffernan and Fu, 2008).

43
3.3 Determinants of Profitability

Generally, previous studies on bank profitability divided profitability determinants

into two categories, namely, internal and external variables. Internal variables can be

broadly classified into two categories: financial statement variables and non-financial

statement variables. External variables are variables outside the control of bank

management (Haron and Wan, 2004). Among the widely discussed external variables

are competition, regulation, concentration, market share, ownership, scarcity of

capital, money supply, inflation and size.

The internal variables used by Haron and Wan in their study were liquidity, capital

structure, deposits structure, assets structure and expenditure item. While the external

variables used were market share, money supply, interest rate, inflation and size of the

bank.

Hassan and Bashir (2003) used four measures of performance in their study. The

measures were the net non-interest margin (NIM), profit margin, returns on assets

(ROA), and returns on equity (ROE). In order to assess the relationship between

performance and internal bank characteristics, their analysis utilized several bank

ratios namely fund source management, funds use management, leverage and liquidity

ratios.

Internal variables used by Mamatzakis and Remoundos (2003) in their research to

examine the determinants of the profitability of the Greek commercial banks were

44
personnel expenses to assets ratio, natural logarithm of banks asset and its value

squared, bank ownership status as a dummy variable and equity to assets ratio. They

also used variables such as concentration ratio measured by Herfindahl index,

consumer price index, narrow money supply and Athens Stock Exchange yearly

percentage change to evaluate the external effects on banks profitability.

Kosmidou et al. (2006) used five internal variables as profitability determinants in

their study. The variables were cost to income ratio as an indicator of efficiency in

expenses management; ratio of liquid assets to customer and short term funding to

represent liquidity; ratio of loan loss reserves to gross loans, as an indicator of banks

asset quality; ratio of equity to total assets representing capital strength; and the total

assets of a bank representing its size.

In this study, five measures are used as internal determinants of performance. They

are: loan loss reserves to gross loan (LLR) which represents the banks asset quality;

ratio of equity to total assets (EA) represents capital strength; cost to income ratio

(COSR) as an indicator of efficiency in expenses management; and lastly, ratio of net

loans to total assets (NLA) and liquid assets to deposit and short term funding (LIQ)

to represent liquidity.

3.3.1 Internal Variables

Five internal variables are examined in this study, namely loan loss reserves to gross

loans, cost to income ratio, equity to asset ratio, net loans to total assets, and liquid

45
assets to deposit and short-term funding. They are also classified as bank-specific

variables. The description of these five variables is given in this section.

Efficiency: Cost to Income ratio (COSR)

COSR is one of the most focused on ratios currently and measures the overheads or

costs of running the bank, the major element of which is normally salaries, as

percentage of income generated before provisions. It is a measure of efficiency

although if the lending margins in a particular country are very high then the ratio will

improve as a result. It can be distorted by high net income from associates or volatile

trading income (Hassan and Bashir, 2003).

Samad (2004) used COSR as one of the financial measures in his study to evaluate the

profitability performance of the banks. COSR is defined as cost incurred per dollar

generation of income or in other words, income generated per dollar cost. It is indeed

considered to be one of the best indices for measuring economic efficiency or profit

performance. The lower the COSR ratio, the better is the profitability performance of

a bank.

COSR is used as an indicator of efficiency in expenses management. COSR measures

the overheads or costs of running the bank, including staff salaries and benefits,

occupancy expenses and other expenses such as office supplies, as percentage of

income. It is typically used as an indicator of managements ability to control costs.

Since higher expenses normally mean lower profits and vice versa, COSR is expected

to have a negative effect on bank profits and margins (Kosmidou et al., 2006).

46
Asset Quality: Loan loss reserves to Gross loans (LLR)

Ratio of loan loss reserves to gross loans is a measure of banks asset quality that

indicates how much of the total portfolio has been provided for but not written off.

Assuming a similar charge-off policy, a high ratio could signal a poor quality of loans

and therefore a higher risk of the loan portfolio. However, with a sound quality of

loans, a high ratio could imply a positive relationship between risk and profits,

according to the risk-return hypothesis. It is therefore difficult to hypothesize the sign

of this relationship although a negative impact this ratio on bank profitability would

suggest a poor quality of loans that reduce interest revenue and increase the

provisioning costs (Kosmidou et al., 2006).

LLR is the percentage of the total loan portfolio that has been set aside for bad loans.

Higher provisioning signals the likelihood of possible future loan losses, though it

could also indicate a timely recognition of weak loans by prudent banks. So the

expected sign on this coefficient is ambiguous (Heffernan and Fu, 2008).

Capital: Equity to Asset ratio (EA)

Equity to asset ratio (EA) is a measure of capital adequacy, calculated as equity

capital as a percentage of total assets. EA provides percentage protection afforded by

banks to its investment in asset. It measures the overall shock absorbing capacity of a

bank for potential loan asset losses. The higher the ratio of EA, the greater is the

capacity for a bank to sustain the assets losses (Samad, 2004).

47
EA is a ratio which measures the ability of the bank to withstand losses. A declining

trend in this ratio may signal increased risk exposure and possibly capital adequacy

problem (Hasan and Bashir, 2003). The ratio of equity to total assets is considered one

of the basic ratios for capital strength. It is expected that the higher this ratio, the

lower the need for external funding and therefore the higher the profitability of the

bank. Additionally, well-capitalized banks face lower costs of going bankrupt which

reduces their costs of funding (Kosmidou et al., 2006). The ratio EA is used as a

proxy for measuring the impact of capital structure on profitability. It is hypothesized

that the higher amount of capital injected, the more confident customers will be and

the more deposits that will be placed at the bank.

Liquidity Performance

Net Loans/Total Assets (NLA) is a liquidity ratio which indicates what percentage of

the assets of the bank is tied up in loans. The higher this ratio the less liquid the bank

will be (Hassan and Bashir, 2003). Higher ratios may be indicative of better bank

performance because of increases in interest income. However, very high ratios could

also reduce liquidity and increase the number of marginal borrowers that default. Its

affect on bank performance is therefore ambiguous.

Liquid assets to deposit and short-term funding (LIQ) is used to measure the

relationship between liquidity management and specifically the process of managing

assets and cash flow to maintain the ability to meet current liabilities as they come

due. Without the required liquidity and funding to meet obligations, a bank may

quickly fail, or at least be technically insolvent. The higher the value of this ratio, the

48
more liquid the bank is. Since liquid assets are associated with lower rates of return, a

negative relationship is expected between this variable and performance.

3.3.2 External Variables

External variable generally includes macroeconomic variables, industry-specific or

financial market structure. However, this study concentrates only on two

macroeconomic determinants, which are GDP growth and inflation.

GDP growth

Gross domestic product (GDP) is among the most commonly used macroeconomic

indicators and it is a measure of total economic activity within an economy. The real

GDP growth, used in this study, is expected to have a positive impact on banks

performance according to the well-documented literature on the association between

economic growth and financial sector performance.

GDP growth reflects the state of the economic cycle and is expected to have impact

on the demand for bank loans as well. Among previous studies which used GDP

growth as one of the profitability determinants were Kosmidou et al. (2005),

Pasiouras et al. (2007), Heffernan and Fu (2008) and Kosmidou et al. (2006).

49
Inflation: Consumer Price Index (CPI)

Inflation is the rate at which the general level of prices for goods and services is

rising. Inflation affects the real value of costs and revenues although it may have a

positive or negative effect on profitability depending on whether it is anticipated or

unanticipated. In the first case (i.e. anticipated inflation) banks can timely adjust

interest rates, which consequently results in revenues that increase faster than costs,

with a positive impact on profitability. In the second case (i.e. unanticipated inflation)

banks may be slow in adjusting their interest rates resulting in a faster increase of

bank costs than banks revenues. This will consequently have a negative impact on

bank profitability (Pasiouras and Kosmidou, 2007).

This paper uses Consumer Price Index (CPI) as a proxy for inflation. Other studies by

Mamatzakis and Remoundos (2003), Athanasoglou et al. (2008) and Haron and Wan

(2004) also used CPI as one of the external variables to represent inflation.

Revell (1980) contended that inflation could also be a factor contributing to the

variations in a banks profitability. He proposed that inflation affected banks through

a number of different routes such as interest rates and asset prices, exchange rates and

operating costs.

3.4 Methodology

In line with past literature, a panel regression is employed to examine the

determinants of the profits of Islamic banks. The content of the model is:

50
Profitability = b0 + b1(LLR) + b2(EA) + b3(COSR) + b4(NLA) + b5(LIQ) + b6(GDP)

+ b7(CPI)

Where,

Dependent variable

Profitability = ROA, ROE or NIM.

Independent variables:

LLR = Loan loss reserves to gross loan ratio

EA = Total equity to total assets ratio

COSR = Cost to income ratio

NLA = Net loans to total assets ratio

LIQ = Liquid assets to deposit and short-term funding

GDP = GDP growth rate

CPI = Consumer price index

This paper uses multiple regression analysis to investigate the determinants of Islamic

banks profitability. The regression models are conducted for three dependent

variables, namely ROA, ROE and NIM as proxies to profitability measures.

51
3.5 Data Analysis Techniques

Financial ratios of 60 Islamic banks obtained from BankScope database and

macroeconomic variables of 18 countries are systematically compiled using Microsoft

Excel. This study uses multiple regressions to examine the factors that determine the

profitability of Islamic banks. Multiple regression is a method of regression analysis

that uses more than one explanatory variable to predict values of a single dependent

variable (Becker, 1995). SPSS software is applied to obtain the regression and t-test

results. SPSS is among the most widely used programs for statistical analysis in social

science. A t-test is any statistical hypothesis test in which the test statistic has a

Student's t distribution if the null hypothesis is true.

There are a few different methods of analysis employed by past researches to evaluate

the performance of banks. Among them are cointegration approach, Promethee

method, CAMEL rating, multiple regression, ordinary least squares (OLS) model and

GMM estimator.

Haron and Wan (2004) in their paper, used cointegration and error correction model

to examine the factors that determine the profitability of Islamic banks. Cointegration

enables the estimation of a relationship among non-stationary variables where

cointegration in the variables simply reveals the existence of a long-run equilibrium

relationship among them. Error correction model (ECM), which is derived from

cointegration, shows how this equilibrium relationship is achieved, i.e. indicates the

short-term dynamics in the movement towards this long-run equilibrium.

52
Samad (2004) applied t-test in assessing the statistical difference between two types

of banks. Athanasoglou et al. (2008) applied GMM estimator to investigate the

determinants of Greek banks profitability. Kosmidou (2008) used multi-criteria

Promethee method to evaluate the performance of commercial and cooperative banks

in Greece. The Promethee method can be considered as an extension of the CAMEL

rating system, which is widely used in the assessment of banking performance.

53
CHAPTER 4: RESEARCH RESULTS

4.1 Summary Statistics

Before moving on to estimation issues, it is useful to remark on some preliminary

features of the data, as revealed by the descriptive analysis. Table 4.1 below describes

the data by presenting the number of banks by country and by year. Meanwhile Table

4.2 exhibits the descriptive statistics for all variables used in this study. Next, the

position of Malaysian Islamic banks in the world ranking in terms of ROA and ROE

is given in Appendix D. Lastly, Appendix E reports the correlation matrix between all

variables used in this analysis.

Table 4.1: Number of Banks by Country and by Year

Country / Year 2002 2003 2004 2005 2006 2007 TOTAL

Bahrain 1 1 1 4 5 3 15

Brunei 0 0 0 0 1 0 1

Egypt 2 1 2 2 2 0 9

Indonesia 0 2 2 2 2 2 10

Iran 0 0 2 2 3 1 8

Jordan 2 2 2 2 2 0 10

Kuwait 0 0 1 3 3 2 9

Lebanon 0 0 1 0 0 0 1

Malaysia 0 0 0 2 5 6 13

Pakistan 0 1 1 0 2 3 7

Qatar 2 2 2 2 2 3 13

Saudi Arabia 0 0 1 0 1 2 4

Sudan 0 1 0 2 3 0 6

54
Tunisia 1 1 1 0 0 0 3

Turkey 0 0 0 2 4 4 10

UAE 2 2 4 4 6 6 24

United Kingdom 0 0 0 0 1 1 2

Yemen 2 2 2 1 1 1 9

TOTAL 13 15 22 28 43 34 155

Table 4.1 above shows the country-wise and year-wise breakdown of the Islamic

banks. A total number of 18 countries and 155 observations are obtained for the year

2002 to 2007, which is in six years period. Initially, there were 260 observations of

unbalanced panel data of 90 Islamic banks from 23 countries were obtained from the

database. However, after eliminating cases with missing data, only 155 observations

of balanced panel data are left. The data are obtained from BankScope database,

compiled by International Bank Credit Analysis Limited (IBCA) and World

Economic Outlook 2008 database, published by International Monetary Fund (IMF).

The year 2006 has the highest number of observations which is 43 in total. Whilst

country-wise, UAE and Bahrain has the highest number of counts with 24 and 15

observations respectively. Due to data availability in BankScope database, Malaysia

has only 13 observations in the six-year period.

4.1.1 Descriptive Statistics

Descriptive statistics for the data compiled in this analysis is given in Table 4.2. The

mean and standard deviation for each variable are given in the table. The mean shown

is the average value of dependent as well as independent variables from the year 2002

to 2007. Total number of balanced panel data is 155.

55
56
A mean is the sum of the observations divided by the number of observations. It is

often quoted along with the standard deviation, where mean describes the central

location of the data, and the standard deviation describes the spread. Mean is also

described as a measure of central location defined by the arithmetic average, which is

the sum of the values in a data set divided by the number of values (Becker, 1995).

Standard deviation on the other hand, is a measure of the dispersion or variability of

the data. In essence, this is the average distance of any data point in the distribution

from the arithmetic average. In other words, standard deviation is the amount of

variation from the mean (average) within a single data set. The greater the standard

deviation, the greater is the range (difference between the highest and lowest values)

of values within the sample.

The mean for dependent variables return on assets (ROA), return on equity (ROE) and

net non-interest margin (NIM) are 2.25, 14.43 and 3.70 percent respectively.

Meanwhile the standard deviations are 3.79, 14.25 and 2.58 percent correspondingly.

Seven independent variables are selected for this study. This includes the internal and

external variables. The ratio loan loss reserves to gross loans (LLR) is the proxy used

to represent asset quality. The average of LLR in the data is 3.76 percent and it has a

standard deviation of 3.42 percent. The ratio of equity to total assets (EA) is used in

57
this study as a measure of capital adequacy. The mean for EA is 16.66 percent and its

standard deviation is 13.77 percent.

Cost to income ratio (COSR) provides information on the efficiency of the

management regarding expenses relative to the revenues it generates. The mean value

for COSR is 61.01 percent and it deviates 69.21 percent from the mean. NLA is

defined as net loans to total assets. It is a liquidity ratio which represents the

percentage of assets that comprise the loan portfolio. Its average value is 53.20

percent and the standard deviation is 20.49 percent.

LIQ is described as liquid assets to deposits and short-term funding. 15.82 percent is

the average LIQ in this data and it has a high standard deviation of 56.26 percent.

GDP is a macroeconomic variable and is an acronym for gross domestic product

growth. Its mean and standard deviation is 6.76 and 2.70 percent respectively.

Consumer price index (CPI) which is the proxy for inflation has a mean of 6.43

percent and 4.09 percent standard deviation.

4.1.2 Position of Malaysian Islamic banks in world ranking

Appendix D exhibits the position of Islamic financial institutions worldwide based on

the two most widely used performance measures which are return on assets (ROA)

and return on equity (ROE). These lists are taken from BankScope database.

Both rankings prove that the position of Malaysian Islamic bank is in the top 30

Islamic banks in the world. The table reports that the value of return on assets for

58
Bank Islam Malaysia Berhad is 1.49 percent, compared to the highest ROA which is

18.33%. Bahrain gained the uppermost position while Malaysia is ranked at 23 rd

place. ROA is an indicator of how profitable a company is relative to its total assets

and it shows how efficient management is at using its assets to generate earnings.

Other Malaysian Islamic banks namely CIMB Islamic Bank Berhad and Hong Leong

Islamic Bank Berhad are ranked at 25th and 26th place.

In terms of return on equity, it is reported that Malaysia is in the first position with

65.58 percent of return, gained by Bank Islam Malaysia Berhad. ROE is an indicator

of profitability and it shows how efficient a bank is at generating profits from every

dollar of net assets, and shows how well a bank uses investment dollars to generate

earnings growth. From the table, it is revealed that the subsequent place after Bank

Islam Malaysia Berhad are attained by Bahrain and Sudan Islamic banks with 44.52

percent and 35.82 percent of return on equity correspondingly.

4.1.3 Correlation between Variables

Appendix E exhibits a square symmetrical matrix which describes the correlation

among the variables in this study. A correlation matrix is similar to a covariance

matrix. The diagonal elements, which are the correlations of variables with

themselves, are always equal to 1.

Equity to total assets (EA) has a significant relationship with NLA, LIQ, GDP and

ROA. All of which are statistically significant at the 1% level. The highest strength of

correlation observed is between EA and liquid asset to deposit and short-term funding

59
(LIQ). Next is efficiency variable, cost to income ratio (COSR) is negatively

significant to NLA. Most of other variables have negative relationship with COSR,

including two profitability measures, ROA and ROE. This is consistent with the

results obtained by Heffernan and Fu (2008) which suggested that more efficient

banks perform better.

There is a positive association between net loan to total assets ratio (NLA) and return

on equity (ROE). This suggests that profitability increase with net loans. On the other

hand, NLA is negatively correlated to EA, COSR and LLR. Liquid assets to deposit

and short-term funding (LIQ) is only significant when correlated to EA and GDP.

Both give positive impact to liquidity.

Gross domestic product growth (GDP) has an effect on numerous factors related to

the supply and demand for loans and deposits. From the correlation matrix, it is

observed that GDP has an inverse relationship with cost to income ratio. Meanwhile,

other variables such as EA, LIQ, ROA and ROE have positive significant effect on

GDP. This is consistent with previous study, for example, Kosmidou (2008) who

reported that GDP has a significant and positive impact on ROA. Inflation, which is

represented by Consumer Price Index (CPI) variable, has a significant positive effect

on NLA and negative effect on LLR. Return on assets (ROA) is positive significantly

associated to EA, COSR, GDP, NIM and ROE. The correlation coefficient is highest

when associated with ROE.

Net non-interest margin (NIM) is positively significant to three variables namely

ROE, ROA and CPI. Both ROE and ROA are profitability measures same as NIM.

60
Return on equity (ROE) has a significant relationship with most of the variables in

this study; they are COSR, NLA, GDP, CPI, ROA and NIM. Loan loss reserve to

gross loan (LLR) is only statistically significantly related to NLA and CPI. Both

present a negative effect on the variable.

4.2 Regression results

Table 4.3, 4.4 and 4.5 report the estimated models for ROA, ROE and NIM

respectively. The first column presents the coefficient for each independent variable

which shows the strength of influence between the determinants and the profitability

measures. Column two presents the t-value which indicates the significance of the

regression results.

Return on Assets (ROA)

Table 4.3 exhibits the estimated model for return on assets (ROA). Three variables are

found to be significant to ROA, namely EA, COSR and GDP growth. The R square

for ROA is 0.370, which means that 37% of the sample describes ROA. This model

generates the highest R square and F-value compared to ROE and NIM. Its constant

coefficient is a negative value, which is -2.908.

61
Table 4.3: Regression results for determinants of Return on Assets (ROA)

Variables Coefficient t-value

LLR 0.095 1.135

EA 0.107 5.357

COSR -0.016 -3.940

NLA 0.029 1.926

LIQ 0.003 0.676

GDP 0.274 2.763

CPI 0.085 1.319

Constant -2.908

R square 0.370

F-value 12.321

. The full equation could be written as below:

ROA = 0.095 (LLR) + 0.107 (EA) 0.016 (COSR) + 0.029 (NLA) + 0.003 (LIQ) +

0.274 (GDP) + 0.085 (CPI) 2.908

Return on Equity (ROE)

As per Table 4.4, two independent variables which are significant in this regression

model are cost to income ratio (COSR) and GDP growth (GDP). COSR produced the

highest t-value among all variables in these three profitability models which is 5.487.

The explanatory power for ROE which is indicated by R square is 36.4%. The

constant value for this model is 2.992.

62
Table 4.4: Regression results for determinants of Return on Equity (ROE)

Variables Coefficient t-value

LLR 0.096 0.305

EA -0.039 -0.521

COSR -0.084 -5.489

NLA 0.105 1.851

LIQ -0.005 -0.305

GDP 1.347 3.591

CPI 0.348 1.422

Constant 2.992

R square 0.364

F-value 12.019

The full equation could be written as below:

ROE = 0.096 (LLR) - 0.039 (EA) 0.084 (COSR) + 0.105 (NLA) - 0.005 (LIQ) +

1.347 (GDP) + 0.348 (CPI) + 2.992

Non-interest Margin (NIM)

As indicated by Table 4.5, the explanatory power (in terms of R square) for NIM is

rather low. Besides that, F-value for this model is only 1.945. Only two determinants

are found to be statistically significant in this regression. They are loan loss reserves

to gross loan ratio (LLR) and inflation (CPI). It has a constant value of 0.841.

63
Table 4.5: Regression results for determinants of Non-Interest Margin (NIM)

Variables Coefficient t-value

LLR 0.147 2.144

EA 0.003 0.206

COSR -0.002 -0.465

NLA 0.019 1.571

LIQ 0.002 0.491

GDP 0.080 0.984

CPI 0.115 2.175

Constant 0.841

R square 0.085

F-value 1.945

The full equation could be written as below:

NIM = 0.147(LLR) + 0.003 (EA) 0.002 (COSR) + 0.019 (NLA) + 0.002 (LIQ) +

0.08 (GDP) + 0.115 (CPI) + 0.841

Equity to Total Assets (EA)

Hypothesis 1 argued that profitability has a positive and significant relationship with

equity to asset ratio (EA). The ratio of equity to total assets is used in this study as a

measure of capital adequacy. Capital adequacy refers to the sufficiency of the amount

of equity to absorb any shocks that the bank may experience. It is expected that the

higher the equity to assets ratio, the lower the need to external funding and therefore

the higher the profitability of the bank.

64
Capital strength makes a significant contribution to the profitability of the Islamic

banks, as the relatively high coefficient of the equity to assets ratio (EA) shows on

ROA. The t-value for its correlation with ROA is very high, which is 5.357, indicates

that the relationship is highly significant. EA appeared as the most significant

determinant of return on assets in this study. EA is also positively significant for the

NIM performance measure. Therefore, the results support Hypothesis 1. This finding

is consistent with previous studies (Demirguc-Kunt and Huizinga, 1999; Kosmidou et

al., 2006; Pasiouras et al., 2006; Athanasoglou et al., 2008; Heffernan and Fu, 2008).

This indicates that well capitalized Islamic banks face lower costs of going bankrupt,

which suggests reduced cost of funding or lower need for external funding, implying

higher profits.

In contrast, the coefficient of EA on ROE is negative. According to Athanasoglou et

al. (2008), it is not appropriate to include EA in a profitability equation, when ROE is

the dependent variable.

Loan loss reserve to gross loan ratio (LLR)

Hypothesis 2 proposed that loan loss reserve to gross loan ratio has a positive and

significant relationship with profitability measures. In this study, the analyses produce

a positive coefficient on LLR for all dependent variables. This finding suggests that

loan loss provisioning improved performance. One explanation could be that banks

differ in their risk attitudes and those taking more risks could enjoy greater immediate

profits.

65
This ratio indicates how much of the total portfolio has been provided for but not

charged off and is used as a measure of banks asset quality. As such, the positive

impact of LLR on the profitability measures could be rationalized by the similar

charged-off policy. The higher the ratio, the poorer the quality and therefore the

higher the risk of the loan portfolio will be. On one hand, the risk-return hypothesis

implies a positive relationship between risk and profits. Thus, higher LLR could result

in higher profitability.

The impact of LLR is significant only on NIM, suggesting that higher risks result in

higher margins for Islamic banks (and therefore supporting the risk-return

hypothesis). On the other hand, the effect of LLR on ROA and ROE is not significant.

Kosmidou et al. (2006) in her study on the UK commercial banks obtained similar

results for both ROA and NIM.

Cost to Income ratio (COSR)

Hypothesis 3 suggested that cost to income ratio would be a negative function of the

profitability of Islamic banks. As expected the coefficient of COSR is found negative

and significant in all cases, suggesting that efficiency in expenses management is a

robust determinant of Islamic bank profits. The COSR is the financial ratio that does

best in all estimations. The COSR is negatively signed and significant for all types of

performance (except for NIM) suggesting that more efficient banks perform better

(Heffernan and Fu, 2008). As such, this finding supports Hypothesis 3.

66
The inverse effect of COSR coefficients on the profitability measures suggests that

the lower the COSR ratio, the better is the profitability performance of a bank.

Besides that, the results also suggest that higher expenses mean lower profits and vice

versa. This is one of the reasons why COSR has a negative effect on bank profits and

margins. Thus it is learned that efficient Islamic banks operate at lower costs.

Pasiouras (2007), Kosmidou et al. (2005) and Kosmidou et al. (2006) among others

also found poor expenses management to be among the main contributors to poor

profitability. Kosmidou et al. (2006) and Pasiouras et al. (2006) also confirm this

inverse relationship for the UK and European banks respectively.

Net loans to total assets (NLA)

Hypothesis 4 argued that net loan to total asset ratio (NLA) has an inverse and

significant relationship with profitability. From the analyses in this study, the ratio of

loans to assets is found to have a positive but insignificant effect on the profitability

of Islamic banks. The coefficient of NLA shows a consistent value in ROA, ROE and

NIM regression models. This is in line with Mamatzakis and Remoundos (2003) who

discovered that the ratio of loans to assets has a positive effect on the profitability of

the Greek commercial banks, especially in the case where the dependent variable is

ROE. Likewise, Bourke (1989) found a strong positive relationship between liquidity

and bank profitability. Hence, the result obtained is not consistent with the hypothesis.

67
In contrary, prior studies for example Demirguc-Kunt and Huizinga (1999)

discovered that NLA gave a negative and significant impact on bank profitability.

Heffernan and Fu (2008) however, found mix results for NLA.

NLA is a measure of liquidity which denotes the percentage of bank assets that are

tied up in loans. To avoid insolvency problems, banks often hold liquid assets that can

be easily converted into cash. According to Hassan and Bashir (2003), the higher this

ratio the less liquid the bank will be. Higher ratios may be indicative of better bank

performance because of increases in interest income. The positive impact of NLA on

performance indicates that lower liquidity would be associated to higher profitability.

This is due to the fact that liquid assets are usually associated with lower rates of

return, and therefore higher liquidity would be associated with lower profitability.

Liquid assets to deposit and short-term funding (LIQ)

Hypothesis 5 stated that profitability has an inverse and significant relationship with

liquid assets to deposit and short-term funding ratio (LIQ). This study shows mix

results in terms of LIQ. This ratio is positively correlated to ROA and NIM, but it has

a negative relationship with ROE. LIQ is found statistically insignificant for all

profitability measures. This result does not support Hypothesis 5.

Referring to previous literature on liquidity, the results are mixed as well. For

example, Heffernan and Fu (2008) discovered that it is positively related to ROA and

ROE, but it has negative effect on NIM. Nevertheless, Kosmidou (2006) revealed a

68
negative and significant relationship between bank profitability and the level of liquid

assets held by the bank.

LIQ is a measure of assets in the form of cash (or easily convertible into cash). The

higher the value of this ratio, the more liquid the bank is. From the analysis, the

inverse relationship found between LIQ and ROE indicates that liquid assets are

associated with lower rates of return. Higher liquidity for the bank means fewer funds

for investment. Hence, lower rates of return are gained.

GDP Growth (GDP)

Hypothesis 6 proposed that GDP growth is a positive significant function of Islamic

banks profitability. The macroeconomic variable that performs best is the real GDP

growth rate. As expected, a rise in the real growth rate boosts bank performance for

ROA, ROE and NIM. The positive impact of GDP growth supports the argument of

the positive association between growth and financial sector performance, and is also

confirmed by Kosmidou et al. (2006) and Hassan and Bashir (2003).

GDP growth is defined as an increase in the production levels of goods and services

and is used as a measure of total economic activity within an economy. This variable

reflects the state of the economic cycle of a country and it affects the demand for bank

loans as well. Hence, an increase in GDP growth would improve bank profitability.

According to Kosmidou et al. (2006), GDP growth was found to have a significant

and positive impact on ROA. In line with previous studies, this study also found that

69
GDP growth gives positive impact on profitability measures. The results are

significant for ROA and ROE. Hence, this finding supports Hypothesis 6. In addition,

the high significant value of this variable shows the importance of including

macroeconomic variables when testing bank performance.

Consumer Price Index (CPI)

Hypothesis 7 mentioned that profitability has a positive and significant relationship

with inflation. Haron (2004) found that inflation was positively related to all

profitability measures, but their relationship was not statistically significant. Whereas,

Hasan and Bashir (2003) found that inflation is only significant on ROA. In this

study, using CPI as a proxy for inflation, the results show that the index has a positive

relationship with all profitability measures. This finding is consistent with Hypothesis

7. It is learned that CPI has a significant effect on ROA and NIM, but is insignificant

on ROE.

Inflation is the rate at which the general level of prices for goods and services is

rising. When it is anticipated, banks can timely adjust interest rates, which

consequently results in revenues that increase faster than costs, with a positive impact

on profitability. With this, bank performance could be improved. Revell (1980)

proposed that inflation affected banks through a number of different routes such as

interest rates and asset prices, exchange rates and operating costs. Inflation was found

significant and positively associated to profitability by most studies such as

Athanasoglou et al. (2008), Kosmidou et al. (2006), Pasiouras et al. (2007), Haron

and Wan (2004) and Demirguc-Kunt and Huizinga (1999).

70
CHAPTER 5: CONCLUSION AND RECOMMENDATION

5.1 Research Summary

This study specifies an empirical framework in an attempt to investigate the impact of

bank-specific characteristics and macroeconomic conditions on Islamic banks

profitability, measured by return on assets (ROA), return on equity (ROE) and non-

interest margins (NIM). A balanced panel data set of 155 observations of Islamic

banks in 18 countries, covering the period 2002 to 2007, provided the basis for the

econometric analysis. The aim is to combine the literature on conventional bank

profitability and the literature on Islamic bank performance, with the purpose of

examining the determinants that influence the profitability of Islamic banks.

5.2 Research Conclusion

This section illustrates the findings revealed from this study. Firstly, among the three

profitability measures, ROA model generates the highest explanatory power. This

finding serve as an indicator that the bank-characteristic and macroeconomic variables

selected for this study provide a better description of return on assets (ROA) rather

than ROE and NIM.

One of the important findings from this study is that some of the determinants have

significant influence on profitability. From the regressions, it is seen that capital

strength, represented by the equity to assets ratio, is found positively related to ROA

and NIM and is one of the main determinant of Islamic banks profit. This finding

71
provides support to the argument that well capitalized banks face lower costs of

external financing, which reduces their costs and enhances profits. Studies for other

countries also support this finding (Demirguc-Kunt and Huizinga, 1999; Kosmidou et

al., 2006; Pasiouras et al., 2006; Athanasoglou et al., 2008; Heffernan and Fu, 2008).

From past evidence, efficiency factor determines the performance of Islamic banks

significantly. In this study, cost to income ratio which served as a proxy for efficiency

factor, is also significant although negatively in all cases, and appeared to be the most

significant determinant of profitability for Islamic banks. This finding is in line with

previous studies such as Pasiouras (2007), Kosmidou et al. (2005) and Kosmidou et

al. (2006).

The impact of liquidity on bank performance is not clear-cut, and varies with the

measure of profitability used. Specifically, liquidity is negatively related to ROE but

positively related to ROA and NIM. The impact of loan loss reserves to gross loans is

not significant and positive on all profitability measures, which suggests that higher

risks result in higher margins. Bank regulators may use this as an evidence for prompt

supervisory action.

Next, favorable macroeconomic environment seems to stimulate higher profits.

Specifically, the macroeconomic environment (proxied by GDP and inflation) is

observed to have a positive impact on bank performance. Higher growth rate of GDP

seem to have a strong positive impact on the performance measures. This is similar to

conventional banks, where GDP and inflation were found in prior literatures as being

significant and positively related to performance as well.

72
The similarity of results of profitability determinants for both conventional and

Islamic banks is a strong indicator that many of the tools and techniques developed in

conventional banking literature are potentially suitable for an Islamic banking

environment.

5.3 Limitations of Research

First of all, the weakness of the present study is that due to data constraints, it focuses

only on two areas of performance measurement: bank characteristic and

macroeconomic condition. This study is limited to only sample of Islamic banks that

are available in BankScope database and World Economic Outlook, from year 2002

to 2007, and furthermore, cases with missing data are eliminated from the analysis.

Secondly, the study was conducted within a limited period of time. This paper did not

include for instance, the effects size of banks, financial structure, as well as taxation

variables on the profitability of Islamic banks.

5.4 Implications

This study provides Islamic bank managers with understanding of activities that

would enhance their banks financial performances. The results of this study imply that

it might be necessary for the bank management to take all the required decisions to

enhance the financial positions of Islamic banks.

73
Knowledge of the underlying factors that influence banks profitability is essential,

not only for the managers of the banks but for numerous stakeholders such as the

central banks, bankers associations, governments and other financial authorities in the

Islamic countries.

The most important finding from this study is that Islamic bank determinants are

revealed to be similar to those of conventional banks. This signifies that many of the

tools and techniques developed in conventional banking literature are potentially

suitable for the Islamic banking environment. Further research is essential to find

more similarities between both banking systems and to discover alternative methods

that could be applied to Islamic banking in an attempt to enhance its performance. If

similarity is established, Islamic banks can thus benefit from conventional banking

literature, to propose a better solution in order to achieve better performance.

The need to enhance the profitability of Islamic banks is vital because it will

consequently boost Islamic economy. This is necessary, as indicated in the Sunnah

and the holy Quran, because it would help to prosper Islamic countries and provide a

better living for Muslims. Islam intends that the gifts of God to the society to be used

to the maximum extent by the society, reasonably, without any waste or prodigality

through responsible freedom, social justice, and just distribution. Islam emphasizes its

control of the processes of gaining and consuming wealth (Ahmad, 1994).

By attaining a stable economy, Islamic banks can give more loans to help the nation

and Muslims mainly, world-wide. Thus, Islamic countries would prosper and thrive in

any industries and would simultaneously eliminate poverty. Islamic principles

74
formulate a perfect way of life. Wealth is distributed through zakat to poor Muslims

and there would be no more poverty. Islamic banking will also provide a better

alternative that is interest-free and also profitable to Muslim depositors and investors.

There will be no more unfair burden of high rates of interests imposed on borrowers,

because Islam prohibits riba. This study is extremely essential to Muslim community

and society. It attempts to identify techniques for Islamic banks to make more profit

and increase performance in an effective manner.

In addition, Islamic banking is indeed significant and relevant to the current economic

crisis. The global financial meltdown stemming from the US subprime woes actually

poses an opportunity for the Islamic finance system to demonstrate its uniqueness.

The financial meltdown showed the desperate need for a system like Islamic finance,

which is based on the principle of profit-sharing where both parties are subjected to

potential losses and returns. It is fair and equitable. This is unlike conventional

system, where Islamic banks do not buy or trade debt; rather they manage concrete

assets which are tied to real economic activities. Following the global economic crisis,

observers were considering the Islamic system with envy and respect as it prohibited

speculative excesses. As a result, mutual respect and recognition would emerge within

Islamic financial industry global community. This is truly an opportunity for the

Islamic financial community to prove to the global market that the Islamic financial

system is truly a robust and viable alternative to the conventional system.

This paper would contribute in resolving current issues in Islamic banking, by

contributing to the existing research on the relationship between Islamic banks

75
performance and Islamic financial development as a whole. This study will serve as

impetus for future works related to Islamic banking literature.

5.5 Suggestion for Future Research

Further research covering a longer time period with a wider range of economic

conditions could reveal some new insights. In addition, the combination of variables

drawn from the conventional banks profitability literature with those of Islamic

banks performance literature into a single model could capture the factors affecting

the profits of Islamic banks more accurately.

This study can be extended to include more Islamic banks of other countries. The

study may also be extended to cover other fields of performance measurement such as

effectiveness, economy, prudence and soundness of Islamic banks in the world.

A comparative analysis of Islamic banking requires further research. This study can

be extended to investigate the magnitude of strength of internal and external variables

on Islamic bank profitability, compared to conventional banks.

In view of the globalization of the markets and the reformed financial environment

that has been created, a study of the Islamic banks efficiency system based on

financial, stock market and strategic criteria is worth conducting.

76