Efficiency and Profitability in Islamic Banking

Introduction

Since the opening of the first Islamic bank in Egypt in 1963, Islamic banking has grown rapidly all over the world, fulfilling the needs of both Muslims and non-Muslims alike. Its operations now include deposit taking and lending as well as all other aspects of banking and financial services.

There are currently 500 financial institutions operating in more than 75 countries worldwide offering Islamic banking and finance products1. Dubai Islamic Bank, established in 1975, operates in a dual banking environment and was the first private Islamic bank designed to achieve maximization of profit on a commercial platform, offering commercial consumer products and banking intermediary services. It led to the development of what is now known as the “Islamic window” concept; a segregated division of a conventional financial institution specializing in Shari’a-compliant products and services. Today, many countries have allowed conventional banks to set up Islamic window operations2, opening the way for prominent international banks to offer Islamic banking and finance products and services.

The popularity of the “Islamic window” operations has significantly spurred the growth and development of the Islamic banking sector. Studies have shown that the industry will continue to grow at a rapid pace in the coming years. GIFR 2011 research indicates that the Islamic banking industry is set to achieve an estimated 10% in- crease after nearly 20% annual growth rate for the last one decade. The current size of the industry stands at USD 1.1 trillion (a slight increase from the USD 1.03 trillion as reported by GIFR 2010). This remains well below the potential size of the industry, which is no less than USD 4 trillion.

The Islamic financial market is currently most developed in Iran, Saudi Arabia, Malaysia, and the majority of the GCC countries. In Malaysia, a country which has been recognized as an Islamic banking hub for the east, the Islamic banking industry has been growing at an average rate of 18.9% per annum in terms of assets since the year 2000. The Malaysian Islamic banking sector’s total assets accounts for approximately 12.8% of the banking system’s total assets, while the market share of Islamic deposits and financing stood at 14% of the total banking sector’s total deposits and financing.

Despite having undergone considerable developments during the past few decades, empirical evidence on the performance of the Islamic banking sector is still in its infancy. Furthermore, studies on Islamic banks have generally focused on theoretical issues, and empirical works have relied on the analysis of descriptive statistics rather than rigorous statistical estimation (El-Gamal and Inanoglu, 2005).

Efficiency performance of Islamic banks

There are at least three reasons to why the study of the efficiency of Islamic banks is important. First, an improvement in cost efficiency means achieving higher profits and increasing the chance of survival in deregulated and competitive markets. This is particularly relevant for Islamic banks as they compete head-on with conventional banks in many areas. Second, customers are interested to know about the price and quality of bank services as well as any new service that banks could offer. This would be influenced by a bank’s overall efficiency of operations. Third, an awareness of efficiency features is important to help policymakers formulate future policies which would affect the banking industry as a whole.

Although literature examining the performance of the conventional banking sector is vast, empirical studies on Islamic finance is sparse. However, this is gradually changing as a number of recent studies have sought to apply various statistical methods to examine the performance of Islamic banking sectors worldwide. Among the most notable studies to examine the efficiency of Islamic banks are by Hussein (2003), Hassan and Hussein (2003), El-Gamal and Inanoglu (2005), Sufian (2007), and Hassan (2007). Hussein (2003) provides an analysis of the cost-efficiency features of Islamic banks in Sudan between 1990 and 2000 estimating cost efficiency for a sample of 17 banks over the period. The analysis is novel as Sudan has a banking system based entirely on Islamic banking principles. The results show large variations in the cost efficiency of Sudanese banks with foreign-owned banks being the most efficient, whilst state-owned banks were found to be the most cost inefficient. The analysis is ex- tended to examine the determinants of bank efficiency. Here, he finds that smaller banks are more efficient than their larger counterparts. In addition, banks that have higher proportion of musharaka and mudaraba finance relative to total assets also have efficiency advantages. Overall, the substantial variability in efficiency estimates is put down to various factors, not least the highly volatile economic environment under which Sudanese banks have had to operate over the last decade or so.

In another study on the Sudanese Islamic banking sector, Hassan and Hussein (2003) examined the efficiency of the Sudanese banking system during the period of 1992 and 2000. During the period under study, the Sudanese banking system had exhibited 37% allocative efficiency and 60% technical efficiency, suggesting that the overall cost inefficiency of the Sudanese Islamic banks were mainly technical (managerially related) rather than allocative (regulatory) causes.

El-Gamal and Inanoglu (2005) looked at the cost ef- ficiency of Turkish banks over the period 1990-2000. The study compared the cost efficiencies of 49 conventional banks with four Islamic special finance houses (SFHs). The Islamic firms comprised around 3% of the Turkish banking market. Overall, they found IFIs to be the most efficient due to their emphasis on Islamic asset-based financing which led to lower non-performing loans ratios. Furthermore, the SFHs achieved high levels of efficiency despite being subjected to branching and other self-imposed constraints such as the inability to hold government bonds.

The Malaysian Islamic banking sector has also attracted researchers’ interest. Among others, Sufian (2007) examined the efficiency of the Malaysian Islamic banking sector during the period 2001-2004. The empirical findings from the study indicate that scale efficiency outweighs pure technical efficiency in the Malaysian Islamic banking sector, implying that Malaysian Islamic banks have been operating at a non-optimal scale of operation. He suggests that the domestic Islamic banks have exhibited a higher technical efficiency compared to their foreign Islamic bank peers. He suggests that during the period of study the foreign banks’ inefficiency was mainly due to scale rather than management.

The study by Hassan (2007) is among the few per- formed to examine the efficiency of Islamic banks in a cross-country setting. The findings indicate that during the period 1993-2001, Islamic banks have exhibited a relatively higher profit efficiency compared to cost efficiency. He suggests that the main source of inefficiency is allocative rather than technical. Similarly, his results suggest that the overall inefficiency was output related. The results indicate that on average the Islamic banking industry is relatively less efficient compared to their conventional counterparts.

Issues and challenges

Existence of economies of scale is an impetus for banks to grow larger, but such benefits may not necessarily outweigh the costs that larger financial institutions impose on the economy. If size benefits outweigh costs, limiting size of banks is not prudent, and such restrictions will push bank risk-taking outside the regulatory parameters. It is preferable that the policymakers impose costs on complex and large financial institutions commensurate with their contribution to systematic risks. Meas- ures could include imposing capital charge and improving macro-prudential supervision of the financial system (Mester, 2010). Such prudential macro-regulation is more apt for Islamic banking industry as they have a universal banking character, which necessarily makes them more complex organizations.

At a time when the conventional banking sector is facing many challenges relating to the credit crunch, Islamic banking is progressively taking the centre stage. In some countries, foreign Islamic banks have been allowed to enter their once-closed banking system. In Malaysia, steps have been introduced to liberalize the banking sector to participation from the foreign Islamic banks. Other financial centres like London, Singapore, and Hong Kong are also entering business partnerships with banking institutions from the Middle East.

On the one hand, the move augurs well in terms of innovation and development of Islamic banking products and services. The large multinational banking players may have added advantages stemming from their wide international presence to mobilize Islamic banking funds from the Middle East, as well as their dynamism and innovativeness in introducing and promoting new Islamic banking and finance products to cater for the domestic market’s needs. They may also possess inherent economies of scale as a direct extension of their other international operations and so are capable of competing with the incumbent banks.

On the other hand, the entry of new foreign players into the domestic markets will heighten competition, necessitating the smaller Islamic banks to consolidate and cascade down into a need for smoother transitions that maintain Shari’a compliance. The smaller Islamic banks will have to strive harder to enhance their efficiency and productivity so as to remain competitive, profitable, and most importantly durable. Furthermore, banks failing to follow best practice methods and exhibiting low-cost efficiency have the tendency to fail (Berger and Humphrey, 1992; Wheelock and Wilson, 1995; Barr et al. 2002).

It is obvious that the role and responsibilities of IFIs are to serve the financial needs of their various stakeholders, while giving proper consideration to the legitimacy of their operations from a Shari’a point of view (Ahmad, 2006). In mainstream economics, where in principle the promotion of private (individual) self-interest is considered primal for enhancing social well-being, efficiency and productivity criteria for banks had to remain focused on profit, which is the main reason for them being in business. For Islamic banks too, profit adequacy is a requirement for survival but it is supplemented by auxiliary considerations. Furthermore, if an Islamic bank’s profit is higher, it will definitely pay more zakat and be able to offer more attractive profit/loss sharing ratios on deposits and loans.

Another issue pertaining to the Islamic banking and finance sector is the need to adapt to a more universal banking model. By doing so, Islamic banks may be able to offer more non-traditional banking products such as salam and istisna (sale by order), mudaraba (partnership of skill and capital), and musharaka (joint venture) compared to bay’ muajjal and ijara, which are the most commonly used modes of financing currently. These products will prove to be potent for entrepreneurial development, as the products are relatively collateral-free. By carrying an equity flavour and risk-sharing values, Is- lamic banks can play a significant role in developing new entrepreneurial-friendly products not readily found in conventional banking. In the absence of money lending environment, entrepreneurs should stand a better chance to flourish and perform even better. This in turn, could help nurture the establishment of entrepreneurial activities and in the long run, is expected to flourish the growth and development of the micro-enterprises.

Other issues facing the Islamic banking community is the need for money market instruments that are Shari’a-compliant. There is also an immediate need for short-term money market investments and tools for liquidity management, a space that could benefit immensely from the introduction of new instruments. Most available conventional banking instruments for liquidity management are interest-based and therefore not Shari’a-compliant. Until new products or solutions are developed, this issue is going to severely hinder development on the Islamic banking inter-bank money market.

Determinants of profitability amongst Islamic banks operating in dual banking

The lack of academic endeavour to conduct research into Islamic banking and finance are pronounced by a dearth of comprehensive pertinent data and information. The studies so far have not adequately compared the determinants of profitability of Islamic banks with that of conventional banks. Hassan and Bashir (2005) appears to be amongst the very rare academic attempts to delve into the factors that determine profitability of Islamic banks and in turn, comment on the commercial viability of Islamic banks. This study demonstrates a positive relationship between capital and profitability as well as between loan-to-asset ratio and profitability. In addition, their study indicated a positive relationship between overhead and profitability. Notwithstanding these findings, there were no follow-up studies under- taken to further examine the causes for the positive relationship between capital and profitability amongst Islamic banks. Such positive relationship appears to be counterintuitive to conventional wisdom.  None of the surveyed literature undertook a comparative study at the same time, into the patterns and the extent of the differences between the determinants of profitability for Islamic banks, and for those of conventional banks, all of which operate within a dual banking system. The studies into such differences, if any, between the profitability determinants of Islamic banks and conventional banks that operate side by side within the same market place, can be of relevance and significance from the perspective of evaluating the commercial viability of Islamic banks as a true alternative to the conventional banks. In this regard, the surveyed literature pertaining to Islamic banking, in particular, those of Bashir (2000) and Bashir and Hassan (2005) delve straight into the analysis of the determinants of profit- ability amongst Islamic banks without any attempt to compare performance of conventional banks with those of the Islamic banks operating in the same country.

Within most dual banking systems, Islamic banks that operate alongside conventional banks, do not have as large a capitalization, asset base and well diversified talent pool as compared to their conventional counterparts. Comparing the performance of Islamic banks with those of conventional banks may well shed some light as to what the differences are and how significant those differences bring to bear in establishing the true worth of Islamic banks as a viable investment and commercial proposition. Islamic banks worldwide are embarking to catch up to conventional banks in terms of services, market coverage, efficiency and market share. Understanding the differences, if any, between the determinants of profitability of Islamic banks and those of conventional banks operating within the same marketplace, will hopefully provide some touchstones as to how a blueprint can be structured in operating and regulating Islamic banks, strictly as profit-seeking entities, rather than instruments and conduits through which self serving political and religious agenda are attained.  A study was undertaken comparing the performance of Shari’a-compliant banks with conventional banks. The data used was drawn from six Arabian Gulf countries and three Muslim-dominant countries in South East Asia. Historical financials from one hundred and twenty six banks spanning from 1998 to 2005 were extracted from Bankscope databank compiled by International Bank Credit Analysts Association (IBCA). Table 2 below gives a breakdown as to the number of Islamic banks and conventional banks that were surveyed. However, the number of banks as surveyed is not exhaustive and there are some banks in the countries under survey, the financials of which had not been included in the Bank- scope databank. For instance, no historical financials were provided for Al Rajhi Banks in Saudi Arabia in the Bankscope databank. Likewise, the historical financials of Kuwait Finance House in Kuwait were similarly not included as part of the databank in Bankscope.

Findings

Table 3 (see appendix) sets out the findings as to how Islamic banks differ from their counterparts.

When examined in means terms, Islamic banks (though only 10% of the total banks surveyed), scored better than conventional banks in pre-tax profit as percentage of total assets, other income as percentage of total as- sets and net income as percentage of total assets. How- ever, what appears to be startling is the measurement of return on equity, i.e. net income as percentage of total shareholders’ equity. In this regard, Islamic banks’ return on equity is roughly 1/3 of that achieved by conventional banks.

In terms of operational costs, Islamic banks demonstrated a higher mean score for cost to income ratio and staff expenses as percentage of total assets. As for capital adequacy measures, Islamic banks registered higher ratios in equity as percentage of total assets, equity as percentage of deposits and short term funds and marginally higher in the case of capital funds as percentage of total assets. Bankscope database defined capital funds as an aggregate of equity, hybrid capital and subordinated debt. As expected, Islamic banks did not register noticeable subordinated debt as a percentage of capital funds. Islamic banks commanded about 60% of tier 1 capital adequacy ratio of conventional banks. This could be explained by the fact that conventional banks can raise perpetual non-cumulative preference shares as part of their tier 1 capital structure requirements whilst Islamic banks are not able to raise preference share capital due to Shari’a constraints. Given that Islamic banks cannot access subordinated debt and hybrid capital in raising tier 2 capital, naturally the total capital adequacy ratio of Islamic banks are lower than that of conventional banks. As for total assets, Islamic banks appeared to have an asset base roughly 1/4 of that of conventional banks.

With regards to liquidity management, Islamic banks appeared to be over 38% more liquid than conventional banks when measured in terms of liquid assets as percentage of deposits and short-term funds. Lower loan-to-deposit ratio of Islamic banks indicates that Islamic banks are not generating sufficient financings/loans from their deposit base, as compared to conventional banks. A higher inter-bank ratio amongst conventional banks underscored the inability of Islamic banks to deploy their excess liquid assets into loans to other banks given Shari’a constraints and lack of development of an Islamic inter-bank market. Bankscope’s database had defined inter-bank ratio as money lent to other banks divided by money borrowed from other banks. A higher ratio implies the bank concerned is a net placer of funds.

As for asset quality, the message appears to be mixed. Islamic banks appeared to have nearly 2.5 times more non-performing loans as percentage of equity when compared to conventional banks. Conventional banks provided more loan loss reserves as percentage of non-performing loans and as percentage of gross loans respectively, when compared to Islamic banks. Likewise, conventional provided marginally higher loan loss provisions as percentage of gross loans as compared to Islam- ic banks. However, conventional banks registered 48% more non-performing loans as percentage of gross loans when compared to Islamic banks. Given the above, it appeared that on a comparative basis, conventional banks had to write off more non-performing loans from their gross loans portfolio. The situation may seem dire at the outset without further investigation. It appears that the non-performing loans of Islamic banks warranted a higher write-down on their equity as compared to conventional banks.

Table 4 and 5 (see appendix) below set out cross country comparisons. Bahrain registered the highest pre-tax profits as percentage of total assets, other income as percentage of total assets and net income as percentage of total assets. However, on net income as percentage of total equity, Saudi Arabian banks led with an admirable mean of nearly 21%.

As for operational cost measurement, Bahrain registered highest cost to income and staff expenses as percentage of total assets amongst the nine countries under survey. In terms of capital adequacy, the message is mixed. Bahrain registered highest equity as percentage of total assets. Oman took the lead for equity as percentage of total deposits and short-term funds and capital funds as percentage of total assets. Banks in Saudi Arabia seemed to have the highest mean when it comes to capital funding through subordinated debt. Highest tier 1 capital adequacy ratio was registered amongst Indonesian banks, perhaps underscored by the presence of high perpetual non-cumulative preference shares issued during the Asian financial crisis, to resuscitate banks in dire consequences of recapitalization. Total capital adequacy ratio registered highest mean score amongst Omani banks. Given the size and strength of the Saudi Arabian economy, it is only natural to see banks in Saudi Arabia registered highest mean score for total assets size which was 2.4 times higher than the next highest mean score for total assets size registered by Malaysian banks.

Other than Malaysia and Indonesia, oil and gas produce appeared to be a mainstay of gross domestic product generation for the rest of the seven countries under survey. Qatar, due to its small population, naturally scored the highest gross domestic product per capita. Indonesia registered the highest gross domestic prod- uct growth and gross inflation amongst the countries under survey.

In terms of financial market development, Malaysia leads in the banking markets and stock market. The leadership of Malaysia confirmed that the Malaysian economy is the highest leveraged amongst the nine economies with Malaysia’s total bank credit as percentage of gross do- mestic product outstripping its next closest rival Kuwait by 2.3 times. However, as for stock market liquidity, Kuwait has the most liquid stock market when considered strictly from the perspective of stock market turnover as percentage of stock market capitalization and stock market turnover as percentage of gross domestic product. U AE and Indonesia had a larger banking market as compared to stock market when considered from the perspective of total banking assets as percentage of stock market capitalization. Given the paternalistic instinct of Saudi Arabian government, it is not surprising to find that Saudi Arabia registered the highest mean score in terms of total central bank assets as percentage of gross domestic product.

A definitive analysis examining the extent to which the restrictive capital structure of Islamic banks impacted on their profitability and fee-based income generation capability cannot be fully realized, due to the disparity in the level and quality of disclosure of financials amongst banks in the countries surveyed. We merely reaffirms findings from established literature, that capitalization by shareholders bears positively for generation of profits and fee-based income. After controlling for the country effect, the empirical results demonstrate that there is no noticeable difference between pre-tax profits, other income and net income generated by Islamic banks and conventional banks. This means that within a dual banking system, the results show that

Islamic banks do not enjoy any competitive advantage over and above conventional banks, in the context of generation of pre-tax profits, fee-based income and net income. However, the results clearly show that country effect has an impact upon the type of banking. Put simply, the bases upon which Islamic banks in Malaysia generate pre-tax profits, fee based income and net income may differ from Islamic banks and conventional banks in Bahrain. Likewise, conventional banks in Indonesia would generate pre-tax profits, fee-based income and net income on premises that are different from Islamic banks in Brunei.

The positive relationship between shareholders’ equity and the three performance measurements comprising pre-tax profits as percentage of total assets, other in- come as percentage of total assets and net income as percentage of total assets, reaffirm the findings of many other studies, which state that the extent of capitalization by shareholders impacts positively upon profitability. Empirical results herein show that such positive impact is greatest in the context of generation of pre-tax profits. Be that as it may, net income as percentage of shareholders’ equity demonstrates a negative relationship with shareholders’ equity as percentage of total assets. Perhaps, this suggests that should the pace in the increase in shareholders’ equity outstrip profitability, returns on equity would demonstrate reduction given the enlarged denominator in shareholders’ equity. Total assets of banks do not seem to exert noticeable impact on generation of profitability and fee-based income.

Empirical results also demonstrate that increase in secondary stock market trading could translate into in- creased profitability and fee based income generation for banks, albeit, the positive impact exerted may seem marginal. Of particular interest is the unanticipated country effect on profitability and fee based income generation. In this regard, banks in Qatar appeared to enjoy a higher propensity to generate profits and fee-based income. Given that a great many financial market structure indicators and macro-economic indicators had been dropped as independent variables, due to statistical complications, this chapter cannot conclusively establish what exactly are the telltale signs that distinguish banks in Qatar as prime mover in profitability and fee-based income generation as compared to other banks in this survey.

The positive relationship between staff expenses as percentage of total assets and other income as percentage of total assets, affirms the relevance and applicability of the expense preference behavior theory in the context of generation of fee based income. Such finding is consonant with conventional wisdom that higher staff expenses are deployed towards hiring well-trained staff of quality and experience, the services of whom are required to generate higher value-added fee-based income.

Conclusion

In the final analysis, this chapter reaffirms the previous findings as outlined in the surveyed literature that capitalization by shareholders affects profitability positively. However, it is yet to be examined what contributes to the differences in profitability and fee based income generation by Islamic banks, as compared to their conventional counterparts operating within the dual banking system. At this juncture, it would appear that if ever there are differences or distinguishing features, the restrictive capital structure of Islamic banks as a factor does not seem to have contributed to the premises upon which profitability and fee-based income are generated for Islamic banks and conventional banks operating within a dual banking system setting. Notwithstanding the above, the intertwining impact between country effect and type of banking system as shown in the empirical results may pave the way for future research into performance of Islamic banks and conventional banks of the same country operating in foreign countries. Such research may be meaningful given that the winds of change brought to bear by globalization compel banks to compete outside their respective comfort zone of home country advantage.