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Competitive conditions in Islamic and conventional banking: A global perspective
Rima Turk Ariss
Lebanese American University, Business School, P.O. Box: 13-5053, Beirut, Lebanon
a b s t r a c ta r t i c l e i n f o
 Article history:
Received 26 October 2009Received in revised form 27 January 2010Accepted 3 March 2010Available online 11 March 2010
Keywords:
Bank competitionPanzar and Rosse methodLerner indexIslamic banks
I analyze the competitive conditions prevailing in Islamic and conventional global banking markets, andinvestigate the possible differences in pro
tability between these markets, using a sample of banks across 13countries during 2000
2006. The results suggest that Islamic banks allocate a greater share of their assets to
nancing activities compared to conventional banks, and they are also better capitalized. Different computedmeasures of competition indicate that Islamic banking is less competitive compared to conventional banking.A second-stage analysis shows that pro
tability signi
cantly increases with market power, but this does notwarrant higher pro
tability levels for Islamic banks.© 2010 Elsevier Inc. All rights reserved.
1. Introduction
Competitioninbankinghasintensi
edoverthepastdecadesandisputting increasing pressure on bank returns. Major
nancial institu-tions are strategically entering new markets and/or offering a diversespectrum of products and services to consolidate their presence andboosttheirpro
tability.Amongsuchdevelopmentsistheexpansionof Islamic banking since 1975, and its growing recognition as a viablemode of 
nancing.Islamic banks have proliferated in the Far East and the Arabian Gulf and a large number of banking
rms have diverted some of theiroperations away from conventional practices by setting up Islamicwindows or establishing full-
edged Islamic banks. Countries likeMalaysia and Bahrain are striving to be regional hubs for Islamic
nancialservices.Therearenowabout270Islamic
nancialinstitutionsworldwide, including banks, mutual funds, mortgage companies, and
Takaful
or insurance
rms. However, Islamic
nance is not limited tostakeholders with common religious backgrounds. Britain has an-nounced plans to turn London into the world centre of Islamic
nance(Kerr, 2007); and international banks such as Citigroup, BNP Paribas,HSBC, and others are also expanding into this new segment of theindustry.In this study, I investigate competitive conditions in Islamic andconventional banking on a global level, and assess the implications of prevailing structures on bank pro
tability. Competitive conditions inbanking are relevant for at least two reasons. First, the degree of market power may bear serious implications for
nancial stability.After the seminal article byKeeley (1990),many studies have shown that competition encourages moral hazard in banking (Hellmann,Murdock&Stiglitz,2000;Jimenez,Lopez,&Saurina,2007),althoughacountertrendprovidestheoreticalpredictionsandempiricalevidencethat more market power might result in higher bank risk (Stiglitz &Weiss, 1981; Koskela & Stenbacka, 2000; Boyd & De Nicolo, 2005;Schaeck, Cihak, & Wolfe, 2009). Second, competitive conditions arelikely to affect bank performance and ef 
ciency (seeBerger & Mester,2003for an updated review of the ef 
ciency literature), in addition toequity capitalization levels (Schaeck & Cihak, 2007).From a structural point of view, Islamic banks operate alongside of conventional banks in different countries and a parallel market forIslamic
nancialserviceshasdeveloped.De
citandsurplusunitsintheeconomyhavethe option touse theservices provided by each modeof banking.Ifreligiousunderpinningsfortheprovisionof 
nancialservicesdo matter, then the bank clientele will choose to transact with full-
edged Islamic banks only. Even if one cannot rule out the possibilitythatcustomersmightestablishrelationshipswithbothtypesof 
nancialinstitutions,Islamicbanks'charterprohibitsthemfromtransactingwithconventional banks unless no payment of a pre-determined rate of interesttakesplaceintheprocess.Inthislight,itisreasonabletoassumethatthetwosegmentsofthebankingmarket(Islamicandconventional)are separate and that inter-industry linkages are limited.Thesegregationofthesetwomarketsisalsovalidfromaregulatoryperspective.Islamicbanksoperateunderdifferentprinciplescomparedto other
nancial institutions and they have unique risk pro
les.Regulatory frameworks generally addresstheir speci
cities in order topromotesoundbankingpractices. Incountrieswhere bothIslamic andconventional banks operate, central banks issue special circulars andpromulgate new laws to cater for the regulation and supervision of Islamic banks. To illustrate, capital requirements to set up an Islamic
Review of Financial Economics 19 (2010) 101
108
Corresponding author. Tel.: +961 1 786456x1644.
E-mail address:
see front matter © 2010 Elsevier Inc. All rights reserved.doi:10.1016/j.rfe.2010.03.002
Contents lists available atScienceDirect
Review of Financial Economics
 journal homepage: www.elsevier.com/locate/rfe
 
bank are much higher compared to those needed for establishing aconventional bank. Another example of industry-speci
c regulationtailored for Islamic banks relates to taxation. Under Islamic
nance,whena customer needsto
nancethe purchase of a physical asset, thebank has to
rst own it before it can sell it to the customer for apremium (cost-plus sales). Thus, the Islamic bank has to payregistration fees, but the end customer will also incur similar feeswiththeconclusionoftransferofownership.Toincreasetheef 
ciencyof the sale transaction and improve the competitiveness of Islamicbanks,severalArabstatesaswellastheUKexemptIslamicbanksfromdouble taxation.This paper differs from previous work on various fronts. First, Iassume thatthere is a globalmarketforIslamic
nancialservices thatisdistinctfromconventionalbankingandthatisnotgeographicallylimitedtoonecountry.Islamic(conventional)bankscompeteamongeachotheron a global level, but not with other conventional (Islamic) banks,because the market segregates them to a certain extent. In countrieswhere capital markets are relatively underdeveloped and where thebanking sector serves as the main conduit to
nance the economy, twoparallel banking markets have developed. I select countries where bothtypes of banks operate, and form two distinct samples of banks, one isconventional and the other is Islamic, to be later aggregated across allcountries considered. No previous study has explored competitiveconditions in both banking segments of the industry.Second, I assess competitive conditions in Islamic and conven-tional global markets using a variety of key indicators, includingtraditional concentration measures, the PR 
-statistic, and the Lernerindex.Previous researchonmarketstructure inrelatedcountriesusestraditional measures of concentration and thePanzar and Rosse(1987)
-statistic either in a single country framework for Islamicbankingorinacross-countrycontextforconventionalbanking.AbdulMajid and Su
an (2007)report that market conditions are monop-olistically competitive in the Islamic
nancial industry in Malaysiausing traditional measures of concentration and the PR method.Al-Muharrami, Matthews, and Khabari (2006)also use traditionalconcentration ratios and the
-statistic and
nd that competitiveconditions in banking vary across the Gulf Cooperation Councilcountries.Turk Ariss (2009)similarly uses the PR model to evaluatecompetitive conditions in Middle Eastern and North African conven-tional banking. No prior study to my knowledge has investigatedcompetitive conditions across both Islamic and conventional globalbanking markets using a spectrum of proxies for competition.Third, unlike previous literature, the analysis extends beyondassessing competitive conditions to explain differences in bankpro
tability across the two market segments, both in absolute termsandonarisk-adjustedbasis,inamultivariateframework.Priorresearchreports that Islamic banks achieve higher records of pro
tabilitycompared to conventional banks using comparative ratio analysis(Samad, 1999; Samad & Hassan, 1999; Iqbal, 2001; Hassoune, 2002).Haron (1996)examines the performance of Islamic banks afterclassifyingtheminmonopolisticorcompetitivemarketsandcontrollingfor bank market share.Bashir (2003) and Hassan and Bashir (2003)considerasetofinternalandexternalbankingcharacteristicsaspossibledeterminantsofIslamicbankingpro
tabilityinacross-countrycontext,and they control for macro-level indicators of competitiveness in theindustry.Iproposetodirectlyinvestigatetheimportanceofcompetitiveconditions on bank pro
tability using both the PR 
-statistic and theLerner index, distinguishing among Islamic and conventional banks.Compared to conventional banking, Islamic bankingis relatively youngin terms of development and it is likely that a higher degree of marketpower prevails in the industry. If market players in the Islamic
nanceindustry do command a higher degree of market power compared totheirpeers,arepro
tabilityconditionsalsosigni
cantlydifferent?Istheembryonic Islamic banking industry a more lucrative business com-paredtothemorematureconventionalbankingindustry?Whataretheimplicationsoftheprevailingstructuresonrisk-adjustedperformance?I
ndthatIslamicbankshavesigni
cantlydifferentassetandportfoliocompositionscomparedtoconventionalbanks.Financingactivitiestieupa large fraction of their assets, and their capitalization is signi
cantlybettercomparedtoconventionalbanks,notwithstandingnon-signi
cantdifferences in pro
tability. All proxies for market structure indicate thatIslamic banks command a higher degree of market power compared toconventionalbanks.This,however,doesnotwarranthigherpro
tabilitylevels for the infant Islamic banking industry.The rest of the paper is structured as follows.Section 2provides abackground overview on Islamic
nance.Section 3presents theevaluation methods used, andSections 4 and 5discuss the data andthe empirical
ndings, respectively.Section 6concludes.
2. Background on Islamic
nance
A commerce law known as
qh al-mu'amalat 
is the basis for theIslamic
nancial system. This law considers issues of social justice,equity, and fairness in all business transactions, and rests on thepromotion of entrepreneurship, the protection of property rights, andthe transparency and sanctity of contractual obligations. Under theprecepts of the Islamic legal code known as
Shari
'
a
, a commercialtransactionispermissibleaslongasitisfreefrom
Riba
(interest),
 gharar 
(uncertainty),
maisir 
(gambling),and
non-halal
(prohibited)activities.
1
Because of its socially responsible and ethical underpinnings, the newclass of Islamic investments is appealing to both Muslims and non-Muslims who seek to invest in socially responsible products.
2
The prohibitionofinterestisnot exclusivetoIslam, but commontoall three Abrahamic faiths. Although the Koran does not explicitly justify the prohibition of dealings based on a pre-determined rate of interest,itisbelievedthattheprimaryreasonfordoingsoistoremoveanyformofinjusticeinbusinesstransactions.While,onthesurface,thismight con
ict with the foundations of conventional
nance withregards to basic concepts such as the time value of money, Islamic
nance mandates a return on capital. However, this return on capitaldependsgreatlyontheperformanceoftheactivitybeing
nanced.Risk-taking, and not the passage of time, justi
es the return on capital. It isnoteworthy that lending and
nancing activities belong to entirelydifferent spheres in Islamic
nance. The
rst falls within the realm of charitytosupporttheneedyintheformofbenevolentloans,whilethesecond is most common in
nancing business activities where thereward is in relation to the investment rate of return.Islamic
nancing services are developing phenomenally around theworld, although most countries do not generally support
riba
-freeenvironments. Recent
gures indicate that global
Shari
'
a
-compliantassets under management stand at about $500 billion (Kerr, 2007).Although the size of the Islamic
nancial industry is still at very lowlevels compared to the $1.5 trillion of pre-2007-crisis assets for someof the largest commercial banks (including Barclays Bank Plc, UBS A.G,HSBS, Citigroup, BNP Paribas, and others), its rate of growth is impres-sive, averaging around 15% over the past three decades (Aggarwal &Yousef, 2000).The development of the Islamic
nance industry coincides withprogress in the legal, accounting and auditing, regulatory, andgovernance fronts. An architecture of institutions has developed tofuel the growth and development of the industry. In 1991, theAccountingandAuditingOrganizationforIslamicFinancialInstitutions(AAOIFI) mandated the preparation of accounting, auditing, gover-nance, ethics, and
Shari'a
standards. In 2002, the Islamic DevelopmentBank based in Jeddah took the lead in establishing the InternationalIslamic Financial Market (IIFM) in April, the Liquidity Management
1
These include pork food, alcohol, and immoral activities such as prostitution andnarcotics.
2
London has become a major trading centre for Islamic funds and a quarter of allIslamic banking business in Malaysia is conducted by non-Muslims (Asokan, 2009).102
R. Turk Ariss / Review of Financial Economics 19 (2010) 101
108
 
Center(LMC) inJuly,and the Islamic Financial Services Board(IFSB) inNovember of the same year. The IIFM has the mandate to take part inthe establishment, development, self-regulation, and promotion of Islamic capital and money markets. The purpose of LMC is to facilitatethe liquidity mismatch of Islamic
nancial institutions through quality
nancial instruments structured in accordance with
Shari
'
a
principles.TheIFSBisanactiveinternationalstandard-settingbodywithamissionto ensure soundness and stability in the Islamic
nancial servicesindustry by developing prudent and transparent standards and codes.Morerecentlyin2005, theInternationalIslamic RatingAgencywassetup to assist Islamic
nancial institutions and instruments in gainingrecognitionlocallyandinternationallybyadheringtogreaterstandardsof disclosure and transparency.Early literature on Islamic
nance focuses primarily on theconceptual viability and sustainability of interest-free
nancing andrecentstudiesaddressvariousaspects oftheIslamic
nancialindustry.ZaherandHassan(2001)provideacomprehensivecomparativereviewof the literature on Islamic
nance, giving a preliminary empiricalassessment of the industryin a cross-countrycontext and highlightingthe challenges that lie ahead.Iqbal (2004)examines
nancialintermediation and the design of an Islamic
nancial system;Shahimi,Ismail, and Ahmed (2006)investigate Islamic banks' involvement invariousfeeincomeactivities.TheworkbySamad(1999)comparestheef 
ciency of conventional and Islamic banks and
nds that Islamicbanks become ine
cient when operating within a dual bankingenvironment. Using
nancial ratios,Samad and Hassan (1999)reportthat Islamic banks outperform conventional banks, andIqbal (2001)
ndsthatIslamicbanksaredoingfairlywellcomparedtoabenchmarksample of conventional banks.Hassoune (2002)similarly reports thatIslamic banks are more pro
table than conventional peers with thesame balance sheet structure.Different studies assess the determinants of pro
tability of Islamicbanks.Haron(1996)dividesIslamicbanksintotwogroupsaccordingtothe market in which they operate, and reports that Islamic banks incompetitive markets are more pro
table than those in a monopolisticmarket.Bashir(2003)analyzesperformanceindicatorsofIslamicbanksand controls for different
nancial structures using the ratio of stockmarket capitalization to GDP and the ratio of total assets of the depositmoney bank to GDP.Hassan and Bashir (2003)similarly consider avariety of internal and external banking characteristics as possibledeterminants of pro
tability of Islamic banks. They use an explicitmeasure of market structure, the three-bank concentration ratio, toshow that banks in concentrated markets achieve higher records of pro
tability.In the next sections, I examine differences in Islamic and conven-tional banking structures. An important assumption in classicalindustrial organization theory relates to pro
t maximization, and itcan be argued that New Empirical Industrial Organization techniquessuch as the PR 
-statistic and the Lerner index cannot be applied toIslamic banks. In principle, the objective of Islamic banks is to ensuresocial and economic justice rather than be primarily guided by theprinciple of pro
t maximization, and this can be mainly achievedthroughthepromotionofrisk-sharing
nancingtechniques.However,aclose look at Islamic banks' balance sheets shows that credit-based
nancing(
murabaha
orcost-plussales)isthedominantformofusesforfunds, while pro
t-and-loss (or risk-sharing)
nancing in the form of 
mudaraba
and
musharaka
nancingrepresenton average less than 10%of assets (Dar and Presley, 2000). This, in fact, might represent anAchilles'heelforIslamicbanks,whichhavebeencriticizedoverthepastthree decades for not abiding by the social aspect of their mission, butrather seeking quicker and more secure pro
ts through
murabaha
nancing.Aggarwal and Yousef (2000)argue that Islamic banks'
nancial instruments are mostly not equity-based because debt-like
nancing is a rational response to the contracting environments. Withthis background and in line with other studies, I assume that Islamicbanks behave as pro
t-maximizing
rms, and derive the PR 
-statisticand Lerner index from the
rst-order condition of the bank's maxi-mization problem.
3. Evaluation methods
I
rst evaluate competitive conditions across Islamic and conven-tional segments of the banking industry using different indicators of market power because the literature on market structure is inconclu-sive regarding the best measure of the degree of competition. In asecond-stage analysis, I investigate differences in pro
tability levelsacross the two market segments in a multivariate context.
 3.1. Traditional measures of concentration
Traditional measures of concentration include concentration ratiosand the Her
ndahl
Hirschman Index (HHI). I use the
n
-bank concen-tration ratio, in particular the C3 and C5 ratios (concentration ratios of thebiggestthreeand
vebanks,respectively)accordingtotheirshareof assets, deposits, and loans in the banking sector. Since concentrationratios do not consider information about the remaining banks, I alsocalculate the HHI by adding up the squares of the market shares of allbanks, using total assets, deposits, and loans. However, such measuresare ambiguous indicators of competitiveness (e.g.Berger, Demirguc-Kunt, Levine, & Haubrich, 2004; Beck, Demirguc-Kunt, & Levine, 2006).Some studies employ the PR 
-statistic to assess the degree of com-petitioninbanking(e.g.Claessens&Laeven,2004;Schaecketal.,2009)andtheLernerindex( Jimenezetal.,2007;Berger,Klapper,&TurkAriss,2009).Inthispaper,Icomputetraditionalmeasuresofmarketstructurein addition to estimating the
-statistic and the Lerner index.
 3.2. The H-statistic 
The PR method rests on the estimation of the following reduced-form revenue equations on pooled samples for each country:ln
TR
it 
ð Þ
=
α
+
β
1
ln
F
;
it 
+
β
2
ln
F
;
it 
+
β
3
ln
K
;
it 
+
γ
1
ln
1
;
it 
+
γ
2
ln
2
;
it 
+
ε
it 
ð
1
Þ
The dependent variable
TR
it 
indicates total revenues measured bytheratioofinterestandnon-interestrevenuestototalassets,followingNathan and Neave (1989) and Casu and Girardone (2006).
3
Eq. (1)includesthreeinputprices:
,it 
asthecostoflaborrepresentedbytheratio of personnel expenses to total assets,
F
,it 
as the cost of fundsrepresentedbytheratioofinterestexpensestototaldeposits,and
K
,it 
asthecostof 
xedcapitalcalculatedastheratioofotheroperatingandadministrative expenses to total assets. Consistent withMolyneux,Thornton, and Lloyd-Williams (1996), Gelos and Roldos (2004) andClaessensandLaeven(2004), theanalysisincludesotherbank-speci
ccontrol variables. The
1
,it 
and
2
,it 
represent the ratioof equity to totalassets and net loans to total assets, respectively, and control for thebusiness and portfolio mix of the bank. While there is no expectationabout the sign on total assets, the results of this estimation provideinformation about whether banks face economies or diseconomies of scale. The subscripts
i
and
refer to bank
i
operating at time
.The PR 
-statistic is computed as the sum of the input priceelasticities of total revenues.Panzar and Rosse (1987)show that the
-statistic can re
ect the structure and conduct of the market towhich the
rm belongs and is interpreted as follows. Under long-runcompetitive equilibrium, an increase in input prices leads to anequivalent increase in total revenues, and
rms that cannot cover the
3
For Islamic banks, the category of 
loans
is substituted by
nancing activities
and interest revenues are called
nancing revenues. Similarly, the
interest expense
item is labeled
nancing expenses.
103
R. Turk Ariss / Review of Financial Economics 19 (2010) 101
108

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