Factors Influencing the Profitability of conventional and Islamic commercial Banks in Gcc countries

Samir Abderrazek Srairi

Abstract: This paper examines the impact of bank characteristics, macroeconomic indicators and financial structure on the profitability of conventional and Islamic commercial banks operating in the Gulf cooperation council (Gcc) countries for the period 1999–2006. Empirical results show that the profitability of both conventional and Islamic banks is affected mainly by three variables: capital adequacy, credit risk (with different sign) and operational efficiency. furthermore, the liquidity ratio and financial risk have only a positive impact on Islamic banks’ profitability. we also found that all macroeconomic determinants, with the exception of inflation rate, are positively significant in explaining profits. finally, as for the effect of financial structure on return on average assets (roAA), the empirical estimation confirms the complementarities between bank and equity market in Gcc countries. In the case of conventional banks, concentration is favourable to banking sector performance. However, there is no evidence indicating a relationship between banking development and profitability.

JEL Classification: G21, C23, O53, P43.

I. Introduction The economies of the Gulf cooperation council (Gcc) countries (Bahrain, Kuwait, oman, Qatar, saudi Arabia and the United Arab Emirates) have witnessed a boom in the last five years as a consequence of record-high oil

Samir Abderrazek Srairi, Assistant Professor of finance, riyadh community college, King saud University, Kingdom of saudi Arabia. © 2009, international association for islamic economics Review of Islamic Economics, vol. 13, no. 1, 2009, pp. 5–30.


Review of Islamic Economics, vol. 13, no. 1, 2009

prices and increased confidence in the region’s future. The Gcc economies are in a relatively strong position as compared to ten years ago and they have collectively shown growth rates much above the world average. In fact, the Gcc banking sector was a main beneficiary of the very favourable economic environment. Indeed, during the period 2001–2006, the total assets of banks, which amounted to Us $310 billion in 2001, have more than doubled to reach over $650 billion in 2006. In terms of profitability, return on equity (roE) for conventional and Islamic banks averaged at 14.5% in 2001, and rose rapidly to 22% in 2006.1 Despite this robust growth, commercial banks in Gcc countries are faced with numerous changes that could impact their profitability, indeed their existence. These changes include the sector’s declining exposure to the government, the opening up of certain markets to foreign competition, the expansion of the private sector and the increase of lending, particularly personal lending, and, finally, the rapid growth of Islamic banking. In the last two decades, Islamic banks have grown in size and number around the world, especially in Gcc countries and in south Asia. According to the Islamic Development Board web site, there were in 2006 about 400 banks licensed as Islamic banks operating in more than 70 countries worldwide. moreover, with the trend towards Islamic financing growing rapidly, most conventional banks in the Gcc countries are now offering Islamic products and are swiftly gaining market shares in the Islamic banking arena. The reason for this thrust into retail Islamic banking is customer demand, which is more inclined to Islamic products as opposed to conventional ones. Islamic banks have several distinguishing features (Ariff, 2007; olson and Zoubi, 2008; chong and liu, 2008). The first principle is the prohibition of interest (riba) regardless of its form or source. Hence, Islamic banks are not allowed to offer or fix a rate of return on deposits and are not allowed to charge interest on loans. The concept of interest is replaced by the profitand-loss sharing (Pls) paradigm. Under the Pls paradigm, the assets and liabilities of Islamic banks are integrated in the sense that borrowers share profits and losses with the banks, which in turn share profits and losses with the depositors. A second principle of Islamic banking is that it avoids investing in any economic activity that is not considered to be of long-term interest to society (e.g. gambling, production and sale of liquor). Therefore, an Islamic bank will not engage in financing activities that are considered unequivocally unlawful (haram) for muslims. finally, the third principle is that any contract of any financial service must have up front all dangers

but are closely pegged to conventional deposits. ranging from one to twelve months. fixed effect model. 13. Kuwait. This paper makes several contributions. Gambling and derivates such as futures and options. gharar (uncertainly and risk) is not permitted. vol. Besides carrying on the comparison between Islamic and conventional banks. we attempt to be the first to distinguish between conventional and Islamic banks. are considered un-Islamic products.Review of Islamic Economics. samad and Hassan (1999) found that Bank Islam malaysia Berhad is less risky compared to a group of eight conventional banks. In view of the rapid growth of the new form of banking. The research uses panel data of Gcc banks that covers the period 1999–2006. in practice. It is the first study for the Gcc countries that analyses the determinants of banks’ profitability. olson and Zoubi (2008) compare conventional and Islamic banks in the Gcc region over the 2000–2005 period. and utilizes linear regression estimated by three empirical models (pooled ordinary least square. no. They also show that only a negligible portion of Islamic bank financing is strictly Pls-based and that Islamic deposits are not interest-free. In contrast. Their results indicate also that Islamic banks are operating with greater risk because they maintain smaller contingency reserves for bad loan-like products. They argue that Islamic banks are profitable but less efficient than conventional banks. 1. furthermore. the aim of this study is to examine the determinants of commercial banks’ profitability in Gcc countries. are not very different from conventional deposits. 2009 7 pre-announced or declared. Qatar. Based on the banking system in malaysia. we intend to analyse how a bank’s specific characteristics and the overall banking environment (macroeconomic indicators and financial structure) affect the performance of commercial banks. Previous studies . and random effect model). Their results suggest that the Islamic deposits. It builds on Bashir and Hassan’s (2003) research which examined the factors influencing banks’ profitability only for Islamic banks in four countries (Bahrain. In Islamic contracting. chong and liu (2008) attempted to establish whether Islamic banking is really different from conventional banking. for example. therefore. because it has more equity capital and its investments in governments securities are much larger than the conventional banks. To this end. they compared Islamic investment rates and conventional deposit rates on savings deposits as well as time deposits of various maturities. UAE) of the Gcc region. several recent researches have examined and compared performance between Islamic and conventional banks. using 26 financial ratios.

operational efficiency and size. free disposal hull: FDH). financial risk. The link between banks’ profitability and internal and external factors has been investigated empirically by means of cross-country regressions. The second group of external factors includes macroeconomic variables (inflation. The final section is a conclusion. vol. asset quality. In this section. II. The research undertaken has applied various methods. and banking sector development) and macroeconomic environment such as inflation rate. including parametric (stochastic frontier approach: SFA. no. interest rate and growth rate in GDP. 2006. The literature classifies the determinants of profitability as internal and external. we will focus on studies that examine the Arab banking system (Bashir and Hassan. olson and Zoubi. growth of GDP and money supply) and financial structure (banking sector development. The group of internal characteristics of banks involves capital adequacy. capital ratios. but reflect financial industry (concentration. distribution free approach: DFA. 13. srairi. External determinants are not related to bank management. but also on recent research . thick frontier approach: TFA) and non-parametric approaches (data envelopment analysis: DEA. 2003. maghyerech and shammout. times series analysis and panel studies or as country case studies. Literature Review The determinants of banks’ profitability have long been a major focus of banking research in many countries around the world. liquidity and operational efficiency. variables and empirical methodology used in the study. 2003. and concentration). 2008). Ben naceur and Goaid. The remainder of the paper is organized as follows: section 2 provides a brief review of the related literature. section 5 describes the data and discusses the results. financial market development. asset quality. 1. The Gcc economies and banking sector are described in section 3. financial market development.8 Review of Islamic Economics. 2009 (Hassan and samad. section 4 presents the data. we examine a variety of variables by introducing internal and external factors that may be important in explaining profits. liquidity. 2008) that examine conventional and Islamic banks focus on financial characteristics that differentiate these two groups of banks and not on whether the internal and external determinants of profitability among conventional and Islamic banks are different. Also. finally. Internal determinants concern banks’ specific characteristics and include measures like bank size. this research uses data from an important number of conventional and Islamic banks (66 banks) and a more recent time-frame by examining the period 1999-2006. 2004.

across countries. vol. study the determinants of commercial banks’ performance in Jordan during the period 1990–2000. 13. 2008) that analyses the effect of bank-specific. maghyerech and shammout (2004). The results also indicate a negative association between the return on equity and overhead ratio (general and administrative expenses/total assets). financial structure and macroeconomic indicators on banks’ net interest margins and profitability in the Tunisian banking industry for the period 1980-2000. commercial banks have to deal with different macroeconomic environments. Kosmidou and Pasiouras. The empirical results of these studies vary significantly because. operational efficiency. 2009 9 (staikouras and wood. 2003.e. industry-specific and macroeconomic determinants on bank profitability. liquidity. and market concentration ratio have no impact on banks’ interest margin and profitability. earning assets to deposits ratio. credit risk (net credit facilities/ total assets). growth rate in GDP. In other single-country studies. and banking sector development. inflation rate and interbank offered rate are insignificant and have a low effect on all indicators of profitability. 2007. They find a positive and significant relationship between size. interest rate and banking development (credit to private sector/GDP). different explicit and implicit tax policies. The results revealed that in case of calculating profitability in terms of ROE or ROA the most significant internal and external factors affecting saudi banks are capital adequacy ratio. financial market conditions and legal and institutional realities (Dermirguc-Kunt and Huizinga. growth rate in real GDP and bank profitability. Ben Ben naceur and Goaied (2006) analyse the impact of banks’ characteristics. GDP). They find also that macroeconomic indicators (i. They concluded that high net interest margins and profitability are associated positively with banks that hold a relatively high amount of capital and with large overheads. However there exist some common elements that we will try to analyse in this paper. A more recent study in this type of research is the investigation carried out by masood et al. He finds also that variables to do with credit risk. no. for instance. 1999). deposit insurance regimes. capital adequacy. However. inflation. . and negatively with the size.Review of Islamic Economics. (2009) to identify the determinants of saudi commercial banks’ profitability for the period 1999–2007. single-country studies investigate the determinants of commercial banks performance in a particular country. financial structure variables (stock market capitalization divided by total assets or GDP) do have a positive effect on the return on assets. 1. Athanasoglou et al.

10 Review of Islamic Economics. The findings of this study revealed that loans-to0-assets ratio and the proportion of loan loss provisions are inversely related to banks’ return on assets. total assets to GDP) are statistically significant and related to both domestic and foreign banks profitability. the results indicated that macroeconomic conditions (inflation. four important results should be emphasized. In the case of foreign banks. economic development and growth in the Gcc The Gcc economies share a number of common features. 13. overview of the Gcc economies and Banking sector 3. indicating a negative relationship between bank profitability and the level of liquid assets held by the bank. on the other hand. the ratio net loans to customer and short-term funding is statistically significant and positively related to the profitability of domestic banks.1. growth of GDP) and financial market structure (stock market capitalization to total assets or to GDP. as well as that banks with the greater levels of equity are relatively more profitable. Bashir and Hassan (2003) study the factors influencing the profitability of Islamic banks in eight middle Eastern countries for the period 1993–1998. This study also indicates a positive relationship between macroeconomic variables. this ratio is also significant but has a negative sign. growth of GDP) had a negative impact on profitability. indicating a positive relationship between liquidity and banks’ profits. staikouras and wood (2003) analyse the performance of a sample of banks operating in 13 European countries. stable currencies and stable price levels (Al-muharrumi et al. dependency on oil exports. first. recently. Kosmidou and Pasiouras (2007) examine how a bank’s specific characteristics and the overall banking environment affect the profitability of commercial domestic and foreign banks operating in the 15 EU countries over the period 1995– 2001. 2009 The second group of studies examines a panel of countries. using a linear model. III. the capital strength (equity to total assets) and the efficiency in expenses management (cost to income) are the main determinants of profitability measured by ROAA. vol. . These countries are characterized by large oil-producing sectors. stock market development and profitability of banks. second. 1. finally. and considers bank profitability as a function of internal and external determinants. no. Third. the authors find no evidence to support the structure–conduct–performance (SCP) hypothesis. 2006). They find that the higher leverage and large loans-to-asset ratios lead to higher profitability. In brief. macroeconomic indicators (variability of interest rate.

rose . Inflation also has remained subdued during most of the period. UAE Total or Average 0.4%2 a year during the period 2002–2006 (7. and especially since 2002. the Gcc economies have been in a relatively strong position and continue to benefit from the sustained rally in oil prices (oil revenues tripled between 2002 and 2005.4 10734 55062 11569 24357 143672 107419 352813 21123 31014 14032 62914 14733 38613 30405 13. nominal GDP.11 30.2 11. In real terms. although it ranged widely from 4. meanwhile.34 4.35 22. Us $ 349 billion in 2002.71 12. 1.29% in saudi Arabia to 10. growing at a 15% average a year. the fall in the Us dollar and the heating-up of the Gcc economies in the later years have ignited inflationary pressures.1 3. over the past decade. Arab monetary fund Database.28 6. rising from 25% of GDP to 38%).2 6. especially in Qatar (11. Impressive economic growth has also lifted the region’s per capita income despite strong population growth. however. oman’s GDP per head was the lowest at $14032 in 2006.546 0.3 Per capita GDP increased from $10939 in 2002 to $30405 in 2006.838 23.35 43.229 35.54 6.Review of Islamic Economics.3%). Positive real growth in 2006 was visible in every one of the six Gcc countries. as well as from the healthy performance of the non-oil sector (8% growth between 2002 and 2005 in real terms).3 5.697 4.34% in Qatar. These include record surpluses in national budgets and record current account surpluses.483 2. The rapid expansion of the Gcc economies is accompanied by other positive economic indicators. for example. has more than doubled to $711 billion in 2006 (Table 1). economic growth averaged a solid 7.29 9.27% in 2006). vol.78 10.242 15823 98717 35729 52722 345138 163293 711425 2.56 27.38 7.8% in 2006) and in the UEA (9. Gcc central Bank.2 3. no.27 Source: International monetary fund.01 27.3 9. 13. 2009 11 table 1: Aggregate economic Indicators of the Gcc countries (2006) nominal GDP (million $) Average inflation (%) Money supply (M2) (million $) nominal GDP Per capita ($) current Account Balance (% of GDP) Real GDP growth (%) country Population (Million) Bahrain Kuwait oman Qatar saudi A. Qatar with a per capita income equal at $62914 far exceeded the average.749 3.8 2. the current account balance for the Gcc. which was $25 billion in 2002 or 7% of GDP.

12 Review of Islamic Economics. 2003. several recent articles (e. and at least three times more is in the pipeline.5 billion) is considerably less than that of one bank in some countries (for example. no. construction and manufacturing sectors have all recorded double-digit growth since 2003. Gcc banks are still small compared to the big international banks.2. having paid down Us$85 billion in debts. whose capital is equal at $35 billion). second. Third. communication. 1. moreover. most banks are characterized by satisfactory asset quality. fourth. Both conventional financial institutions and Islamic banks have been expanding rapidly in the Gcc in recent years. Islam.g. 2003) showed that commercial banks are well capitalized and have adopted modern banking services. transport and storage. 2009 more than eight times in 2006 to reach $204 billion or 29% of the collective GDP. the combined public debt of Gcc countries dropped from 64% to 18% of GDP between 2002 and 2006. saudi Arabia saw the largest decline. a large part of the oil windfall has been used to repay public debt. the public sector continues to have a prominent role in the banking sector of the Gcc countries. the private sector has invested some $120 billion since 2003 in about 500 projects. Indeed. vol. improvements in public services and the systematic removal of infrastructural bottlenecks. 13. 3. the Gcc banking sector The Gcc banking industry has several futures that make it unique and different from other regions (Al-maharrami et al. 2006. All this augurs well for stable and sustained economic expansion. the present oil boom appears to be more sustained and considerably better managed that the first one in the 1970s and early 1980s: less money is wasted. and more reserves are built up and managed in more sophisticated and diversified ways (Hertog. finally. 2008): first. capital adequacy and a high level of profitability. having benefited from the bulk of the private investment. this one has been accompanied by soaring private investment. . the oil windfall and growth in government spending4 have built significant momentum in the business sector. the sector is largely dependent on oil sector activities and protected from foreign competition. the capital of all 50 Gcc banks ($31. Indeed. on another positive note. olson and Zoubi. the banking industry’s main lending activities are concentrated in construction. the Hong Kong shanghai Banking corporation.5 The financial services. Essayyad and madani. 2007). real state and consumer loans. Unlike previous oil booms. projects are more targeted.

The low loans to GDP and deposits to GDP ratios indicate ample room for Gcc banking sector growth.5 33.3% of the combined GDP of the six member countries.6 62. its size amounted to $18. The low assets-to-GDP ratio in a number of Gcc countries6 can be attributed to the existence of an informal economy that does not have access to formal financing. This represents more than 97% of total Gcc GDP. with its loans to GDP ratio reaching 81% in 2006. likewise.78 Deposits (B$) 12002 57760 12014 32775 157669 128287 400507 Deposits to GDP (%) 75. vol.06 Roe (%) 19.6 21. Kuwait. while the UAE and Kuwait were in second and third place with 32% and 14.7 Source: Gcc central Bank.5%. respectively. representing 36% of total Gulf banks’ assets.9 2. oman has the lowest ratio (33%).2 45.2 32.3 18. the equivalent of about 40% of total deposits in Gulf banks. .1 79. UAe total or average Banks 25 9 5 8 11 21 79 Assets (B$) 23092 93346 18724 52055 229623 234216 651056 Assets to GDP (%) 146 94. table 2: Gcc Banking Market size and Performance (2006) country Bahrain Kuwait oman Qatar saudi A. 13.7 78.7 98. followed by saudi banks with about $230 billion in assets. This ratio varies from 146% in Bahrain to as low as 33% in oman.05 Loans (B$) 12744 63346 11697 31162 169353 129111 417413 Loans to GDP (%) 80. 2009 13 Table 2 shows that the total assets of the 79 Gcc conventional and Islamic banks increased from $310 billion in 2001 to $651 billion in 2006. This ratio varies widely among Gcc countries.9 3.2 21 30.5 2.7 66.4 2.1 18.Review of Islamic Economics. no. The smallest banking market among the Gcc countries is the omani banking market. reflecting a pattern commonly seen in developing countries.4 RoA (%) 1.6 2.5 32.1 49. deposits at Gcc banks amounted to more than $400 billion in 2006. similarly. while Bahrain has the highest.1 60. the equivalent of 56. respectively.5 64. from as high as 79% of GDP in the UAE to as low as 34% of GDP in oman. In terms of market share. 1.4 144 97. the ratio loans to GDP is still low in the Gcc countries (equal to at 59% of GDP). or 35% of total assets of local Gcc banks.7 billion and $12 billion in term of assets and deposits. saudi banks attracted $157 billion in deposits. meanwhile.6 59.7 59.8 58. Arab monetary fund Database.2 21. the assets of the UAE amounted to $234 billion in 2006.9 2. Institute of Banking studies.

return on equity (ROE) varied widely. saudi Arabia.7% in 2006. oman. 1.1%. indicating higher profitability relative to other Gulf banks. finance companies and saving institutions are excluded. 2009 Banking profitability can be looked at through ROE and ROA. Qatar. Data The data for this study comprise commercial banks (conventional and Islamic) in Bahrain. table 3: Banks in sample by country and type country Bahrain Kuwait oman Qatar saudi Arabia UAe total conventional Banks 7 6 5 6 9 15 48 Islamic Banks 6 4 2 1 5 18 total number of banks 13 10 5 8 10 20 66 . the size of Gcc banking is relatively slow and eventually these banks will need to grow externally to take competitors on or risk becoming easy targets. with that for saudi banks averaging at 30. no. nevertheless.14 Review of Islamic Economics. As shown in Table 2. despite this robust growth commercial banking penetration rates are still generally low in the Gcc. Deposit-taking companies. But overall. Kuwait.9%. Table 3 presents the number of conventional and Islamic banks by country. 13. Additionally.1. on the other hand. with saudi banks significantly higher at 3. Data and empirical Methodology 4. return on assets (ROA) of Gcc banks averaged 2. Kuwait have relatively more profitable banking sectors. finally. IV. There are 384 observations for conventional banks and 144 observations for Islamic banks. the Gcc banking sector was a main beneficiary of the very favourable economic environment as balance sheets expanded solidly and enhanced profitability. saudi Arabia and the United Arab Emirates. our sample is a balanced panel dataset of 66 commercial banks (48 conventional and 18 Islamic) observed over the period 1999–2006 consisting of 528 observations. commercial banks’ financial statement data for institutions operating in six Gcc countries are sourced from the Bankscope Database of Bureau van Dijk’s company. Qatar. trust banks. vol. all Gcc banking sectors performed better than the standard averages of 10% ROE and 1% ROA.

and the higher will . after adjustments for differences in accounting and reporting standards. Kosmidou and Pasiouras. Therefore. Berger. no. 13. It also indicates the risk of not having sufficient reserve of cash to cope with withdrawal of deposits.2. liquidity. Determinants and variables Table 4 provides a description of the variables used in this research. 4. 1989. the less liquidity the bank has.2. Liquidity: The ratio of net loans to deposits and short-term funding is used to measure the relationship between liquidity management and performance. In order to hedge against liquidity risk. operational efficiency and size. Additionally. It reflects the ability of a bank’s management to generate profits from the bank’s assets. the higher the value of the ratio. comparing data across these countries should not cause any particular problem. 2007) found a positive and strongly significant relationship between bank profitability and capitalization in many countries. financial risk. Capital adequacy: we use the ratio of equity to assets (EQA) to proxy the capital adequacy variable. 1995. Bank characteristics as profitability determinants The internal bank-specific characteristics that we include in our model represent information about capital adequacy. This ratio is computed by dividing the net profits over average total assets. Hence. and also indicates their likely impact on commercial bank profits.Review of Islamic Economics. several studies (Bourke. banks often hold liquid assets to meet advice shocks. the central banks in each country have required all banks (conventional or Islamic) to follow international accounting standards (IAs) in preparing financial statements. 4. and would normally have lower needs for external funding and therefore higher profitability. 2009 15 This study has used data from Bankscope because the financial and accounting information of banks is presented in standardized formats. Banks with high capital ratios would be considered relatively safer in the event of loss or liquidation.1. Average assets are used in order to capture any differences that occurred in assets during the fiscal year. The macro and market-specific data were collected from annual reports published by central banks in each Gcc country and from other sources such as International monetary fund (Imf) and Arab monetary fund (Amf). The profitability variable is represented by the return on average assets (roAA). vol. asset quality (credit risk). 1.

Therefore the indicator (LTA) may have a negative impact on bank profitability. Financial risk: In the absence of guaranteed returns on deposits. . vol. 1. maghyerech and shammout. Bank loans are the main source of revenues. 2007. for Islamic banks. The smaller this ratio. among others. Ben naceur and Kandil. consistently with this argument. 2004) found a strong positive relationship between the ratio of loans to total assets and bank profitability. Islamic banks undertake risky operations in order to be able to generate comparable returns to their customers. we can say from the evidence that the higher this ratio (NLA) is. masood et al. 2009) confirmed this finding. whereas Bourke (1989) found a significant positive association between liquidity and bank profitability. Operational efficiency: this variable is equal to total operating expenses minus provisions for credit losses divided by total operating income (coI8). we use the loan less loss provisions to total assets (NLA)7. we expect a positive relationship between roAA and this ratio. 2003. high risk-taking will expose the bank to the risk of insolvency. if borrowers are able to repay debt and interests. However. Dermirguc-Kunt and Huizinga (1999) and others recently (Bashir and Hassan. the costto-income ratio is expected to be negatively related to profitability. 13. Credit risk: to proxy this variable.16 Review of Islamic Economics. Theory suggests that increased exposure to credit risk is normally associated with decreased profitability and. molyneux and Thornton (1992). we use the ratio of total liabilities to total assets (LTA) as a proxy for this risk. in the absence of deposit insurance. several earlier studies (Pasiouras and Kosmidou. 2008. 2009 be the profitability because liquid assets are usually associated with lower rates of return. LTA is also an indicator of lower capital or greater leverage. maghyerech and shammout (2004) explain the conflicting findings by a different elasticity of demand for loans in two samples. Bashir and Hassan (2003) have found a strong positive association between the ratio of total liabilities to total assets and profitability is measured by the ratio of before tax profit to total assets. It reflects the bank management’s ability to control operating expenses. found a weak inverse relationship. the greater the operational efficiency. but it also considered a largest source of credit risk. the higher the profitability of banks. no. Hence. In this study.

The higher this ratio the less risk assumed by bank. m2=current in circulation of money M2 + Private demand deposits in local currency supply with banks + quasi-monetary deposits. log Total Assets + ROAA The return on average total assets of the bank notation Description expected effect LQR NLA LTA + + + operational Efficiency size COI TA +/- macroeconomic (external factors) (cPIt-cPIt-1)/cPIt-1. 1. the more monopoly power there is in the banking system +/- + + + SMGDP + concentration CONC ? . Assets of the three largest banks/total Assets. loans/Deposits and short-term funding. High ratios are assumed to be indicators of low financial capital leverage and hence low risk. net loans/Total Assets. financial Industry Banking sector Development financial market Development CPGDP credit to private sector/GDP. cost/Income. The higher the concentration ratio. The higher this ratio the less liquid the bank will be. This ratio measures the overall level of development of the market and its importance in financing economy. vol. The higher this ratio. This variable is more than a simple measure of banking sector size. Higher ratio indicates a less efficient management. 2009 17 table 4: Description of Variables Variables Dependent Profitability Independent Bank-specific (internal factors) capital Adequacy liquidity ratio credit risk financial risk EQA Equity/total Assets. GDP is a general Domestic RGDP Product index of economic development Growth Growth rate (m2t-m2t-1)/m2t-1. To proxy this variable we Inflation rate INF use the growth of the consumer Price Index :cPI real Gross (rGDPt-rGDPt-1)/rGDPt-1.Review of Islamic Economics. Total liabilities/Total Assets. no. stock market capitalization/GDP. the higher bank profitability. it also used to measure the importance of bank financing in the economy. This ratio provides information on the efficiency of the management regarding expenses to the revenues it generates. 13.

consequently. we . Growth rate in real GDP: this variable is expected to have a positive impact on bank profitability. 2009 Size: in order to capture possible non-linear relationship between size and profitability (Boyd and runkle. the banks may be slow in adjusting their interest rates. three macroeconomic variables are used: inflation rate. 2007. the performance of banks is related to the relative development of the banking industry and the stock market. or in economies of scope that result in greater loan product diversification and accessibility to capital markets which are not available to small banks (smirlock. like RGDP. Allen and nadikumana.2.2. 1998. 1989. the inflation may have a positive impact on profitability. some studies (Pasiouras and Kosmidou. However. 13. Athanasoglou et al. issued by central bank minus currency with the banks) plus monetary deposits in local currency at commercial banks plus quasi-monetary deposits. 2006) found diseconomies for larger banks. 1993). several studies (Islam. Generally. Financial industry profitability determinants In addition to macroeconomic variables. fritzer. 2004) showed that there is a systematic relationship between financial development and economic growth. 1995. 4. However. Inflation rate: we use the percentage change in the consumer price index (CPI) to proxy this variable.2. vol. 1992. Growth rate of money supply: money supply (M2) consists of money in circulation (currency. Indeed.18 Review of Islamic Economics. 2008) reached similar results.3. no. The impact of inflation rate on bank profitability depends on whether the inflation is anticipated. this indicator (M2) is expected to have a positive effect on performance. most studies (Bourke. the banks can appropriately adjust interest rates in order to increase their revenues faster than their costs and. 1. molyneux and Thornton. for banks that become extremely large. we use the logarithm bank assets (TA) as a proxy for bank size. the bigger the size of the bank the higher the profitability. growth rate in real GDP and growth rate of domestic liquidity. Macroeconomic profitability determinants To isolate the effect of bank characteristics on profitability. 1985). Perry (1992) argued that. 4. This adversely affects bank performance. if the inflation is not anticipated. The reason is that large size may result in economies of scale that will reduce the cost of gathering and processing information. if the inflation is anticipated. notes and coins. the effect of size could be negative due to bureaucratic and other reasons. Ben naceur and Goaid.

CPGDP is expected to impact performance positively (maghyerech and shammout. 2004).t + β2Zt + εi. no.t = α + β1 Xi. Bank concentration: the two main measures of market concentration that have been proposed in the literature are the concentration ratio (CRk) and the Herfindahl-Hirschman Index (HHI). It also indicates the importance of the stock market in financing the economy. on the other hand. 4. 2007) or Islamic banks (Bashir and Hassan. Banking sector development: CPGDP is the ratio of the value of credits by banks to the private sector divided by GDP. ROAAi. Indeed. 13. This variable is used as a proxy for the banking sector size. which is calculated by dividing the total of the three largest banks in the market with the total assets of all commercial banks in the country. 2009 19 consider three external determinants: Banking sector (CPGDP). vol. starting with the positive impact that concentration can have on performance. we use the CRk. the X-efficiency hypothesis is based on the view that a highly concentrated market may result from increased managerial and scale efficiency. 1995). 2003) found this variable to be positively related to bank performance. and is intended to measure the importance of bank financing in the economy. 2003. we adapt the following linear model. 2009). the relative market power (RMP) hypothesis suggests that only banks with large market shares and well differentiated products can exercise market power and earn non-competitive profits (Berger. The relation between banking market structure and bank performance can go either positive or negative.3. several studies concerned conventional (Ben naceur and Goaid.t (1) .Review of Islamic Economics. Kosmidou and Pasiouras. likewise. Financial market development: we use the ratio of stock market capitalization to GDP as a proxy for financial market development (SMGDP). financial market Development (SMGDP) and Bank concentration (CONC). masood et al. Model formulation To identify the internal and external factors that affect the profitability of banks in Gcc countries during the period 1999-2006. williams (2003) examined the Australian market and found that concentration reduces profits of the foreign entrants and acts as an effective barrier to entry. market power allows banks to charge higher loan rates and offer savers lower deposit rate thus increasing the net interest rate margin (Goddard et al. a highly concentrated market can have a negative impact on bank profitability. 2004. 1.

If the null hypothesis of heteroscedastic residual variance is not rejected. REM) is the most appropriate. we use the fixed effect model (FEM) and random effect model (REM). the Hausman specification test (H) is conducted.t represents the vector of characteristics of bank i in year t.t + vi where ui. then the form of regression model is: ROAAi. σ2u). IID: indicates that errors are independent identically distributed. and εi.t ~ IID (0.t ~ IID (0.t + vi is the disturbance term. while random effect is examined by the lagrange multiplier (LM) test.t = α + β1 Xi. it is useful to comment on some preliminary features of our data. we use the random effect model.t = ui. 2009 where ROAAi. empirical Results 5.t = (α + vi ) + β1 Xi. To estimate this model. If vi is considered as an error term. Descriptive statistics Before we analyse factors that influence banks’ profitability. β1 and β2 are the vectors of regression coefficients. V.1. FEM is estimated using the within fixed effect. no. 13. Zt represents the external factors. Using fixed effect regression. vol. Xi.t + β2Zt + ui.t (2) where ui. σ2v ). (3) . 1. σ2u ) and vi ~ IID (0. the pooled ordinary least square (OLS) regression is favoured.20 Review of Islamic Economics.t is the return on average assets for bank i in year t.t + β2Zt + ui. α is a constant. In order to find which of these models (FEM. the bank specific effect (vi) is taken to be constant over time and the functional form of oneway panel data model is as follows: ROAAi. Table 5 presents descriptive statistics for the profitability measure (ROAA) and the variables that describe internal and external factors used in our model. whereas REM is estimated using the feasible generalized least squares (GLS). The fixed effect model is tested by F test.

Review of Islamic Economics. we can see from Table 5 that the average of private credit to GDP ratio (36%) is still far below the comparable level which exceeds 100% for high-income countries. Bolbol and Al Karasneh (2006) show that the banking market in the Gcc countries can be viewed as ranging from moderately to highly concentrated. vol.1%.24 57.18 21. respectively).97 2.28 -1.53 33.Dev. equal to 6.96 93.12 13.02 -1.7%). in 2007 the mean of this indicator in Gcc countries rose to 7%.73 std. likewise.40 31.72 18.70 49.00 936.44 22.53 18.47 8.92 2.06 10.73 The summary statistics show.95%.37 9. however. max = 89. The ratio of concentration is relatively high (with mean 57.83 17.89 97.10 100.60 45.84% and 2. Table 5 reveals that the mean of macroeconomic variables in the Gcc countries such as RGDP and growth rate of money supply (M2) are very high.80 6.30 43. 1.85 Maximum 35.8%). on the other hand.00 89.04 11. 3. The inflation rate during the period 1999-2006 is low (with mean 2.43 89.22 86.60 0.30 13.13 206. respectively. Based on the two measures of bank concentration (i.13 17.94 370.26 6.67 75. 13.26% and median 1.96 Minimum -11.61 Median 2. with Qatar exhibiting the highest concentrated market and UAE the lowest. no.30 59. for example. CRk and HHI).08 53.10 89.99 39. This indicates that the Gcc economies are in a relatively strong position as compared to ten years ago and collectively have shown growth rates much above the world average.12% and 13.07 52. max = 100%).6% and median 50%) and differs widely across the banking sector of the Gcc countries (min = 32%.e.78 10.88 2.77 3.00 3. more importantly.95 4.88 58. that the return on average assets is relatively high (with mean and median of 2. The liquidity ratio is also very high with mean 75% and median 69%.63 15.00 3.00 42. 2009 21 table 5: Descriptive statistics Variable name roAA EQA lQr coI nlA lTA Inf rGDP m2 cPGDP smGDP conc Mean 2.10 35.77 0.84 19.35 1. .69 68.34 80.30%. This means that the banking sector in Gulf countries has ample room for growth. the mean of capital adequacy ratio is large and varies greatly across banks (min =2.

2008. 13.22 with p < 0. several studies (maghyerech and shammout. Indeed. Athanasoglou et al. 1. both conventional and Islamic. providing evidence in favour of a fixed effects model. masood et al. fixed effects model and random effects model.000). we used three alternative models: Pooled ordinary least square. This finding shows that the cost decisions of bank management are instrumental in influencing bank performance. Dermirguc-Kunt and Huizingua. Bashir and Hassan. Ben naceur and Kandil. Three tests are applied to choose between these methods. the difference in coefficients between fixed effect and random effect is systematic. the Breusch-Pagan lagrange multiplier (LM) is calculated. The first column presents the results of all banks in our data. Regressions results To estimate the panel regression model (equation 1).38). 2008) indicate a negative relationship between operational efficiency measured by the overhead ratio or cost to income ratio and banks profits. 2003. Kosmidou and Pasiouras. . However. 1995. Ben naceur and Goaid (2003). 2007. As expected.22 Review of Islamic Economics.14 with a p-value = 0. the coefficient of the cost to income ratio is negative in all cases. we reject the null hypothesis in favour of the random effects model. with the large chi-squared (LM statistic = 456. found a positive association between the return on asset and overhead ratio. vol. since the relevant f statistic is significant at the 1% level (F (65. 2007. The result means that a more motivated (well-paid) staff contributes to the profitability of the banking industry as overhead is mainly composed of wages. This result is consistent with previous studies (Berger. 2004. firstly the F-test shows that individual effects are present. 450) = 7. in the case of Tunisian banks. no. columns two and three report the results for conventional and Islamic banks separately.2. 2009 5. secondly. Table 6 summarizes the empirical results of the estimation of model 2 (within fixed effect) using ROAA as the profitability variable. finally as indicated by the Hausman test (H= 35. The capital adequacy variable (EQA) is highly significant and positively related to ROAA whether we look at conventional or Islamic banks. for the random effects model and in order to investigate whether there is evidence of heteroscedasticity in the residual variance. Kosmidou and Pasiouras. thus we choose the fixed effects model. 2008) providing support to the argument that banks with a sound capital position are able to pursue business opportunities more effectively and can charge more for loans and pay less on deposits because they face lower bankruptcy risks.0004). 1999.

424) 0. 1.54 23.038 (2.023 (1. no.064 (-8. The result indicates a negative relationship between bank profitability and the level of liquid assets held by the bank. 783 (2. vol. 2008) Islamic banks are riskier than conventional banks.36 29.200)** 0. ‘*’.67 384 Islamic banks 0.684) 0.412 185. ‘**’.023 (1.218)** 0. they may hold more cash relative to assets or deposits.001 (0.161 (2.563)** 0.049 (1.927)* 0.958)** 0.413 9.020 (3.029 (2.352 (5. 2008.035) 0.046 (-0.481 (2.017 (1.064 (6.535)* -0.701)* 0.012 (1. 2009 23 table 6: Regression Results (Fixed effect Model) Variables EQA lQr nlA lTA coI TA Inf rGDP m2 cPGDP All banks 0.021 (1.678)* -0. 13.009 (0.054 (2. consequently.704)*** 0.076 (-5.104)** 0.083 (2.216 (2. 5%.316)* -0. According to certain studies (chong and liu.525) 0. The impact of the ratio net loans to customer and short term funding (lQr) on roAA is significant and positive only for Islamic banks.14 528 conventional banks 0.046 (-8.439 (-1.15 144 smGDP conc Adjusted r2 f value lm Hausman test nb.361)** 0.217 (2.Review of Islamic Economics.160) 0.491) 0.449)* 0.358)** 0.049 (5.031 (1. respectively.002) -0.044 (1.368) 0.005 (-1.414 (4.144)* -0.737)*** 0.679 456.166)** 0.097 320.050 (0.233)** 0.248) 0.982)** 0.066 (-1.011 (1.282) -0. and 10% levels.315) -0. observations Notes: t-statistics are between parentheses.456)* 0. olson and Zoubi.22 35.076)* -0.182)* 0.953)** 0.653 61.509 46.015 (-1. and ‘***’ indicate coefficient is significant at the 1%.862)*** 0.018 (2. .

Kosmidou and Pasiouras (2007). the effect of bank size on profitability is negative and unimportant.g. were obtained in other studies in the European market (Kosmidou and Pasiouras. The ratio net loans to total assets is statistically significant and positively related to the profitability of banks. 1985. 1998). found a negative association between size and bank’s profitability for both domestic and foreign banks. ijarah and various Islamic lease back schemes) which may involve less risk than conventional loans. 1. This suggests mainly that if bank size exceeds a certain value. This is consistent with previous studies (e. Genay. This . The financial risk variable (LTA) has a positive and significant effect on return on average assets for all banks and especially for Islamic banks. In fact. no.24 Review of Islamic Economics. Turning to the macroeconomic control variables. 2003). This finding is consistent with previous studies (smirlock. 2007) and in middle Eastern countries (Bashir and Hassan. its profitability tends to be lower (vander vennet. However. Indeed. which support the argument of a positive relationship between banks’ performance and economic growth. vol. 2009 thus the liquidity surplus affects bank profitability negatively because of the opportunity cost of the idle money. 1999. yet has a negative sign. This is line with olson and Zoubi (2008) who found that the equity multiplier (Asset/Equity) is larger for Islamic than for conventional banks. This result reveals the importance of leverage in the practice of Islamic banks and also indicates that Islamic banks undertake more risks than conventional banks. Islamic banks generally use deposits as a type of leverage to achieve higher profitability. 2004). 13. the results are mixed. but this type of leverage means the risk is also shared with depositors. masood et al. 2009). the size variable (TA) is positive and significant for all banks. similar results. contrary to Islamic products (for example. Bashir and Hassan. among others. In the case of conventional banks – and contrary to our expectations – the variable (NLA) is also significant. 2003. Table 6 reveals that the growth rate of money supply (M2) and of real gross domestic product (RGDP) are statistically significant and positively related to both conventional and Islamic banks ROAA. maghyerech and shammout. In Table 6. Table 6 also shows that inflation rate appears to have an insignificant impact on banks’ profitability. so less reserves are needed for bad loans. This result may be explained by the fact that conventional banks maintain higher reserves for loan losses. referring to the credit risk. 2003. Ben naceur and Goaid. if we examine conventional and Islamic banks separately.

It also indicates that a larger stock market relative to the banking sector increases bank profitability. maghyerech and shammout. In contrast. 13. This positive effect is mostly related to the efficiency of more bank lending due to cost advantages as banks reap economies of scale in the production of banking services. finally. Bahrain. vol. Gcc banks. Kosmidou and Pasiouras. (2006).g. some studies (Demirguc-Kunt and Huizingua. conclusion In the context of liberalization. especially in Qatar. who examined Islamic banks in middle Eastern countries found a strong association between ratio of total assets divided by GDP and the ratio of before tax profit to total assets. this is also probably due to the high interest margins that banks earn. the relationship between the concentration indicator and ROAA is significant at the 1% level for conventional banks. Dubai. we see that the stock market capitalization to GDP ratio (SMGDP) and concentration indicator (CONC) have a significant and positive effect on returns on average assets.Review of Islamic Economics. 2007) conclude that if the banking assets constitute a large portion of the GDP. Qatar. the empirical results show that the banking development variable (CPGDP) affects bank profitability positively. and ras Al Kaimah) that posed great challenges to the banks. 2009). earn monopoly profits by working with a wider margin of intermediation. . Bashir and Hassan (2003). This finding about SMGDP suggests that there are complementarities between bank and equity market in Gcc countries. Indeed. the size of the banking sector will have a negative incidence on banks’ profitability. and the UAE have undergone significant changes (new licenses to Islamic and foreign banks. referring to financial structure variables. These changes increased local competition and could have some impact on banks’ performance. according to the study of Al-muharrami et al. saudi Arabia. and oman which are operating under conditions of monopolistic competition. no. 1999. VI. on the other hand. 1. 2009 25 is because inflation during the period 2002–2006 was largely moderate in the Gcc countries. the financial landscapes in Gcc countries such as Kuwait. 2004. masood et al. but this effect is relatively insignificant for both conventional and Islamic banks. These results are in conformity with studies that examined single countries in the middle East (e. new financial free zones in Qatar. This confirms that market structure (SCP hypothesis) has a positive impact on growth in the Gcc banking sector.

The factors that may affect profitability. we adapt linear models to investigate the determinants of banks’ profitability for conventional and Islamic commercial banks operating in Gcc countries between 1999 and 2006. involve bankspecific characteristics. Al-muharrami et al. such as GDP and money supply. the market structure of the Gcc banking industry is widely different in each of the six countries. The difference in the impact of credit risk on profitability can be explained by the value of provisions for possible loan losses which is much higher in conventional than in Islamic banks.26 Review of Islamic Economics. Qatar. measured by the return on average assets. 13. the study showed that this variable is insignificant in explaining profitability. on the one hand. that there are complementarities between bank and equity markets in Gcc countries. Turning to financial structure indicators and their effect on bank’s profitability. The empirical results indicate that the capital adequacy ratio is positively related to ROAA for both Islamic and conventional banks. (2006) found that Kuwait. and financial industry indicators. for all banks. vol. on profitability was significant and positive in all cases. This is probably due to economies of scale and is consistent with previous studies. As far as the banking development indicator is concerned. banks in Bahrain. These institutions are likely to be more liquid than conventional banks. The net loans to assets ratio has a significant impact on ROAA in all cases but with opposite signs for conventional and Islamic banks. The relation between liquidity and profitability is negative only for Islamic banks. This means that the contribution of commercial banking in . and UAE have moderately concentrated markets and are moving to less concentrated positions. its effect on profitability is insignificant. the market structure has a positive impact on growth in the banking sector. In contrast. the size variable has a positive effect on profitability. no. macroeconomic variables. and oman operate under conditions of monopolistic competition. Indeed. likewise. The impact of macroeconomic control variables. on the other hand. 1. saudi Arabia. However. The positive and significant effect of the financial risk variable in the case of Islamic banks reveals the importance of leverage in the practice of Islamic banks. As for the effect of inflation rate. the coefficient of operational efficiency is also significant but has a negative impact on performance in both cases. we found that the stock market capitalization to GDP ratio and concentration were positively associated to ROAA. 2009 In this paper. These results indicate. This finding provides additional support to the strong relationship between economic growth and banking sector performance.

Hence.Review of Islamic Economics. This could be accomplished by building large national champions. conventional and Islamic banks can play an important role in financing large scale investments across the Gcc countries which are estimated at Us$1 trillion between 2006 and 2010. as suggested by olson and Zoubi (2008). The limitations of our study are the following. especially including the years 2007 and 2008. and then go for total liberalization of this region. The fact that the ratio is low (credit to private sector to GDP) shows the existence of ample room for Gcc banking sector growth. Therefore. first. Third. second. moreover. which can form the nucleus of further consolidation on the regional level. furthermore. for example. we can examine the factors influencing banks’ profitability in the middle Eastern and north African (mEnA) countries or. Islamic banks undertake more risk than conventional banks because they deal in new and unfamiliar forms of finance. they may need to be more careful in monitoring and regulators must impose higher capital requirements on this type of banks. 13. 2009 27 financing the economy is still low in the Gcc countries. Gcc countries are expected to open up their banking sector to foreign competition. overall. more largely. finally. several opportunities exist for the banking sector not only in lending but in raising finance through alternative channels such as real estate funds. conventional and Islamic banks need to position themselves and align activities with those in developed countries in order to ensure their continued profitability. vol. 1. and we estimate that the results may be different if a larger time frame is used. with a very favourable economic environment in the Gulf region. according to many studies. it is useful to draw several recommendations and proposals. Yet. it might be better first to liberalize the financial sector between Gcc countries to foster cross-border financial cooperation. it would be interesting to widen the sample of study by adding other countries. some indicators such as inflation and banking development do not seem to affect performance. the time period of analysis is relatively short (8 years). these empirical results provide evidence that the profitability of Gcc banks is shaped by bank-specific characteristics. macroeconomic variables and financial industry. Based on the results of this study. no. . in the whole Arab region. stock market bubble…). which witnessed certain important events (rise in inflation. we did not include some variables in our model such as the ownership status of banks and the business cycle that may affect banks’ profitability. for this reason.

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