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IMEFM
13,1 Islamic ethics, capital structure and
profitability of banks; what makes
Islamic banks different?
116 Kaouther Toumi
Gouvernance and Organizational Control Laboratory LGCO,
Received 1 May 2016 Universite Toulouse III Paul Sabatier, Toulouse, France
Revised 4 April 2017
25 January 2018
21 May 2018
18 September 2019
Accepted 7 October 2019 Abstract
Purpose – The paper aims to investigate whether the Islamic banks (IBs) and the conventional banks (CBs)
could be distinguished from one another on the basis of their capital structure, profitability and their
respective determinants with using a multivariate statistical method for analysis of data.
Design/methodology/approach – The paper provides a comparative study based on a predictive
model, the binary logistic regression, using a sample of 53 listed CBs and 45 listed IBs from the Middle East
region for the period 2006-2014.
Findings – The binary logistic regression reveals that profitability and capital structure are good predictors
that help to distinguish between the two categories of banks. Results suggest that higher are the net margin
and capital ratio, higher is the probability that the bank is Islamic. For the return on assets, results show that
lower is this value; higher is the likelihood that the bank is Islamic. Regarding their related determinants, the
findings suggest first that banks with higher dividend payout policy, financing ratio, costs ratio and
insolvency risk are more likely to be Islamic. Second, results suggest that banks with lower collaterals, size
and credit risk are more likely to be Islamic.
Research limitations/implications – The study contributes to the growing literature on corporate
finance and Islamic banking. Analyzing the capital structure and profitability of the two categories of banks
is important for investors, financial analysts and regulators. Understanding the differences contributes to
understand how following Islamic finance principles and being under Sharīʿah governance could impact the
bank profitability and financial decision, as well as investors behavior.
Originality/value – The study contributes to the scare literature dedicated to the use of the multivariate
statistical methods for the analysis of data to compare the financial characteristics of IBs and CBs.
Keywords Islamic banking, Profitability, Capital structure, Binary logistic regression
Paper type Research paper

International Journal of Islamic
and Middle Eastern Finance and
Management
Vol. 13 No. 1, 2020
pp. 116-134
© Emerald Publishing Limited
1753-8394
DOI 10.1108/IMEFM-05-2016-0061
1. Introduction
Given that a well-functioning and well-developing banking system plays a crucial role in
promoting the growth of an economy, it is imperative to understand factors that sustain a
healthy banking sector. Modern financial theories have always identified profitability and
capital structure as fundamental dimensions for a firm’s survival and continuity, and that
they are not self-stand dimensions but affected by multiple dimensions. Capital structure
theories relate that taxation; bankruptcy costs, conflicts of interest and the associated
information asymmetries and the historical market values determine a firm’s capital
structure (Baker and Wurgler, 2002; Jensen and Meckling, 1976; Myers, 1984; Myers and
Majluf, 1984). Similarly, market theories report that profitability is associated to portfolio
diversification and risk (Lintner, 1965; Markowitz, 1952; Sharpe, 1964).
Taking into consideration the Islamic finance ethics, the financial characteristics of
Islamic banks (IBs), notably their capital structure and profitability, should be affected
compared to conventional banks (CBs). IBs are considered as having an ethical identity, as Profitability of
the foundation of their business philosophy is closely tied to religion (Haniffa and Hudaib, banks
2007). Islamic financial institutions follow an interest-free system that does not rely on
lending and borrowing money for financing purposes and prohibits reward for time
preference only (freedom from al-Riba principle). Any return or benefit must always be
accompanied by liability or risk. Sharing the profits and losses mechanism replaces, in
consequence, the conventional mode of remuneration based on the interest rate (profit and
loss sharing principle). Furthermore, Islamic financial transactions must be tied to tangible 117
underlying assets ensuring that the Islamic financial institutions remain connected to the
real economy (a requirement for traceability of money principle). Additionally, the financial
contracts should be free from excessive uncertainty and any intentionally lack of
information (a requirement for transparency – the right to equal, adequate and accurate
information – freedom from al-Gharar principles). Excessive risk taking and gambling are
also not permitted, which close the access to speculation and conventional derivatives
(freedom from al-Qimar and al-Maisir principle). Finally, Islamic finance requires investing
in sustainable and socially responsible projects (freedom from Darar principle).
Consequently, the respect of the Islamic finance ethics changes IBs business models and
constraints to have different governance and risk management mechanisms compared to CBs.
Financial management of IBs illustrates many dimensions of an alternative finance with an
optimization of many more binding constraints, specific financial products and contracts, new
organizational configurations and new relationships between actors (Toumi et al., 2012). One
major innovation is that IBs mobilize a new category of deposits named the profit-sharing
investment accounts (PSIAs), which are governed generally under Mudaraba arrangement and
designed to achieve an equitable profit and risk-sharing. Such deposits are not considered as
conventional liabilities and are similar to equity, as their value is not guaranteed and may incur
losses in principal. The Sharīʿah governance, insured by the Shariah Supervisory Board (SSB),
represents a second major innovation. IBs are governed under a strict surveillance of such
committees that provide expertize in the Sharīʿah-compliance processes in the bank. Together
with the regular boards of directors and other operational committees, the SSB changes the
governance in IBs into multi-layer governance (Mollah and Zaman, 2015; Toumi et al., 2012).
Such differences should have an impact on the financial characteristics of IBs, notably their
capital structure and profitability that are on the central of the modern financial theories.
The purpose of this paper is to explore how following the Islamic finance ethics could
impact IBs profitability and capital structure compared to CBs. Previous studies focused
more on identifying IBs and CBs determinants of profitability (Athanasoglou et al., 2008;
Dietrich and Wanzenried, 2011; Haron, 2004; Masood and Muhammad, 2012; Noor and
Ahmad, 2011) and capital structure (Bitar et al., 2018; Bitar and Tarazi, 2019; Gropp and
Heider, 2010; Octavia and Brown, 2010; Ben Salah Mahdi and Boujelbene Abbes, 2018) using
panel data regressions. The objective is to investigate whether IBs and CBs can be
distinguished from one another on the basis of their capital structure, profitability and their
respective classical determinants with using a different methodology for the comparative
analysis. Using a sample of 98 listed banks; divided into 53 listed CBs and 45 listed IBs; from
the Middle East region for the period 2006-2014, we run a binary logistic regression.
Results put in evidence that the net margin, the return on assets and the capital ratio are
good predictors that help to distinguish between IBs and CBs. The binary logistic regression
on banks’ capital structure determinants show that collaterals, dividend policy and size are
the best predictors that help to distinguish between both types of banks. The regression on
banks profitability determinants reveal that loans ratio, credit risk, insolvency risk and
costs ratio appear as the best predictors that help to distinguish between IBs and CBs.
IMEFM The study contributes to the scare literature dedicated to the use of multivariate statistical
13,1 methods for the analysis of data to compare the financial characteristics of IBs vs CBs. The
research helps to understand the differences between IBs and CBs and contributes to identify
factors that sustain a healthy banking sector. Profitable and sound banks will contribute
better to economies and spur growth, as well as endure negative and external financial
shocks. Moreover, understanding differences between IBs and CBs contributes to understand
118 how following Islamic finance ethics and being under Sharīʿah governance could impact IBs
financial characteristics. The paper shall not only provide practical implications for Islamic
and conventional bank managers but also illuminate some perspectives to the policymakers
who set rules that encourage and/or discourage the ethical practices in banking.
The paper is organized into four sections. Section 2 provides brief theoretical and
empirical reviews of IBs capital structure and profitability. Section 3 presents the data and
describes the methodology. Section 4 presents and discusses the empirical results. Section 5
concludes the results.

2. Literature review on banks’ capital structure and profitability: Islamic

banks vs conventional banks
2.1 Islamic banks capital structure
Modern corporate financial theories report that taxation, bankruptcy costs, information
asymmetries and conflicts of interest determine the level of capital in financial and non-
financial firms. Toumi et al. (2012) developed the classical theories of capital structure in an
Islamic finance context and found that the Islamic ethical constraints and the involvement of
an SSB in the governance system of IBs could change theoretically their capital structure
compared to CBs.
The trade-off theory suggests that the arbitrage between the tax benefits and bankruptcy
costs determine the optimal ratio of capital in a conventional context. Considering the Islamic
finance ethics, Toumi et al. (2012) argue that bankruptcy costs are lower because of the
principle of tangibility in financial transactions, which would imply a lower capital ratio in IBs.
Based on the pecking order theory, the strong information asymmetry and reporting
issues associated to the equity issuance lead firms to prioritize their sources of financing,
preferring internally generated funds. If internal resources are insufficient, firms prefer
straight debt, then convertible debt, and finally, external equity (Myers, 1984; Myers and
Majluf, 1984). Toumi et al. (2012) stipulate that the requirement for information
transparency, the traceability of money, the investment in sustainable and socially
responsible investments, as well as the participatory financing mechanisms could reduce the
information asymmetries in IBs, and consequently, increase the equity in these banks.
The agency theory suggests that the agency conflicts between shareholders and
managers encourage indebtedness unlike conflicts of interest between shareholders and
depositors (Jensen and Meckling, 1976; Myers, 1977). In an Islamic finance context, the
governance is different from that of CBs because of the higher number of actors involved in
their governance scheme (Abdelsalam et al., 2016; Choudhury and Hoque, 2006; Grassa and
Matoussi, 2014; Mollah and Zaman, 2015). Because of the involvement of the SSB and PSIAs
holders as new actors, the new organizational configurations in IBs lead to new agency
relationships added to the classical managers-shareholders and shareholders-claimholders
depositors’ relationships. Three new agency relationships arise in IBs: the shareholders-
PSIAs depositors, the managers-PSIAs depositors and the managers-SSB relationships
(Toumi et al., 2012). As the capital structure is a result of a trade-off between benefits and
costs associated to the agency relationships, the new ones emerged in IBs and the associated
costs modify IBs capital structure relatively to CBs. Toumi et al. (2012) argue that
agency costs related both to managers-shareholders and shareholders-claimholders Profitability of
relationships should be lower in IBs. In fact, agency costs result from the difficulty for banks
shareholders to control the actions of managers. The transparency requirement and the
prohibition of Gharar advocated by the Sharīʿah require the contractor to be morally
responsible vis-a-vis shareholders. Therefore, the opportunistic behavior should be reduced
leading to less agency conflicts in IBs. The same reasoning could be applied to the
relationship between shareholders and liabilities claimholders where the possibilities of
wealth transfers from shareholders to claimholders are limited by the impossibility for 119
shareholders to engage in highly risky projects. Regarding the additional agency
relationships, the conflicts with these new actors generate additional costs that could modify
the capital structure of IBs (Toumi et al., 2012).
The market timing theory is another conceptual framework that explains capital structure
in firms. A first version of this theory states simply that managers issue equity when they
believe its cost is irrationally low and repurchase equity when they believe its cost is
irrationally high (Baker and Wurgler, 2002). A second version assumes economic agents to be
rational. Firms are supposed to issue equity directly after a positive information release, which
reduces the asymmetry problem between managers and shareholders. The decrease in the
information asymmetry leads to increase in the stock price. Consequently, firms create their
own timing opportunities. In an Islamic finance context, because the information asymmetries
are theoretically lower, IBs would have more timing opportunities to issue equity.
Previous empirical studies reveal that IBs hold a higher proportion of equity compared to
their conventional counterparts (Bitar and Madiès, 2017; Olson and Zoubi, 2008, 2017).
Studies on determinants of CBs and IBs capital structure have appeared recently (Bitar et al.,
2018; Bitar and Tarazi, 2019; Gropp and Heider, 2010; Hamza and Saadaoui, 2013; Octavia
and Brown, 2010). Studies on the determinants of capital structure, which are inspired from
the classical corporate finance theories suggest the size, profitability, market-to-book ratio,
collaterals and dividend payout as the main variables that determine a firm capital level.
Empirical Studies reveal that size is positively related to a firm’s leverage (Aggarwal and
Jamdee, 2003; Booth et al., 2001; Diamond and Rajan, 2000; Titman and Wessels, 1988). The
probability of default is reduced in larger firms, as the business diversification reduces the
volatility of cash flows, and thus, the probability of bankruptcy. In addition, larger firms have
easier access to the bank credit market. Gropp and Heider (2010) and Octavia and Brown (2010)
reveal the same result for the CBs. Bitar et al. (2018) confirm also this result for IBs.
Studies also reveal that profitability impacts a firm’s capital structure. The pecking order
theory suggests a negative relationship between the level of debts and the profitability. The
more profitable are the firms; the more they use internal financing decreasing in consequence
the debt financing needs. The trade-off theory suggests the opposite result. When firms are
profitable, they should use more debts to enjoy the tax benefit. Gropp and Heider (2010) and
Octavia and Brown (2010) demonstrate a negative relationship between the level of debt and
profitability of banks. The same result is found for IBs by Bitar et al. (2018).
The previous literature shows also that guarantees and tangible assets affect positively
the level of debts (Aggarwal and Jamdee, 2003; Rajan and Zingales, 1995). A high proportion
of tangible assets suggest that firms can mobilize more debts secured by these assets. In
addition, the pecking order theory suggests that the higher the tangible assets in firms, the
lesser they are sensitive to information asymmetries and the more they have easily access to
bank credit. Gropp and Heider (2010) reveal that guarantees favor bank debts. Octavia and
Brown (2010) and Bitar et al. (2018) show the opposite result, respectively, for CBs and IBs.
Furthermore, literature reports that firms paying dividends have on average a lower
higher capital ratio. The dividend is a key component of profitability that allows first to
IMEFM retain shareholders interested in high income, and secondly, to convey information between
13,1 managers, shareholders and market (Lintner, 1965; Ross, 1976). According to agency theory
and in case of conflict between shareholders and managers, the former may use the dividend
as a strategic weapon to discipline the later ones and force them to take into account their
interests. The idea of an informational role of the dividend appeared initially in the study of
Lintner (1965), which shows that firms increase dividends when results increase. Change in
120 dividend is a direct signal to the market on the expected results in the future. If dividends
provide a good signal on the future prospects, the firms would issue more equity. So, the
volume of dividends is well known to have a positive effect on the capital level. Gropp and
Heider (2010) find a negative effect of dividends on bank leverage. Octavia and Brown (2010)
find an opposite result.
Finally, the corporate literature suggests the market to book as an additional factor that
determines a firm’s capital structure. A high ratio of market-to-book reflects a strong growth
of investment opportunities giving shareholders a greater choice for future investments.
Firms with high growth investment opportunities have higher costs of bankruptcy that
should limit the use of debt following the trade-off theory. With regard to agency theory, the
existence of growth opportunities promotes the alignment of interests and equity financing
is preferred (Jung et al., 1996). Conversely, from the perspective of pecking order theory
(Myers, 1984; Myers and Majluf, 1984), firms with high growth options and a strong need for
significant funding will primarily use the external funding with less subject to asymmetric
information such as the short-term debt. With regard to market timing theory, firms tend to
issue equity instead of debt when the market value is high, relative to book value and past
market values, and tend to repurchase equity when the market value is low (Baker and
Wurgler, 2002). Empirically, Gropp and Heider (2010) find a negative relationship between
market-to-book ratio and book leverage. Octavia and Brown (2010) find an opposite result,
respectively, for CBs.
To examine whether the capital structure and its determinants help to distinguish
between the two categories of banks, the following hypotheses are tested:

H1. Capital structure is a good predictor that helps to distinguish between IBs and CBs.
H2. Capital structure determinants are good predictors that help to distinguish between
IBs and CBs: H2a. Profitability; H2b. Size; H2c. Dividend; H2d. Collaterals; and
H2e. Market to Book.

2.2 Islamic bank’s profitability

Financial theories suggest that profitability, returns and risk should not be treated
separately (Black and Scholes, 1973; Markowitz, 1952). Considering the Islamic finance
ethics, some features could make IBs less vulnerable to risk than CBs. IBs are better able to
pass negative shocks on the asset side through the profit-sharing arrangement (Mollah et al.,
2016). The overall risk taken by IBs is theoretically lower in the Islamic finance context
when considering the prohibition of Maysir and Gharar principles that eliminate the access
to speculative risky activities. In addition, following the requirement of money traceability,
the investment in sustainably and socially responsible projects and the prohibition of Riba
lead to different forms of portfolios diversification (Chatti, 2012).
The portfolio theory reports that the relation between risk and return can be developed
through diversification that should improve returns (Markowitz, 1952). The market model
suggests that the specific risk can be eliminated through diversification (Sharpe, 1964).
Based on financial market theories, IBs profitability should be affected because of the
different decomposition of IBs portfolios. The market theory based on the leverage Profitability of
relationships suggests furthermore that leverage affects the return on equity (Lintner, 1965; banks
Sharpe, 1964).
The mobilization of the PSIAs changes the capital structure in IBs and reduces thus their
leverage as a consequence of the prohibition of Riba and the requirement of the profit-
sharing principles (Al-Deehani et al., 1999; Toumi et al., 2012). Under Mudharaba contract
that governs PSIAs, IBs share profits with PSIAs holders on the base of a pre-agreed ratio.
Losses on PSIAs funds are to be borne by their holders except in the case of misconduct, 121
negligence or breach of contracted terms by IBs managers. As PSIAs are not guaranteed
funds, leverage is lower in IBs and do not increase the financial risk of IBs shareholders. As
suggest by the corporate financial theories, leverage increases the financial risk, and thus,
the shareholders returns. Theoretically, a different capital structure in IBs and a lower
leverage should decrease the return on equity of IBs shareholders. However, the IB’s
conceptual capital structure is difficult to adopt in practice because of market imperfections.
IBs are forced in fact to guarantee PSIAs deposits and to smooth actual returns offered to
PSIAs holders under commercial or regulatory pressure (Toumi et al., 2011; Toumi and
Viviani, 2013). Returns smoothing practices is an attempt to match market expectations to
avoid massive withdrawals of PSIAs funds by depositors who are sensitive to low return
rates, exposing IBs to specific risk called displaced commercial risk (DCR) (Toumi et al.,
2011, 2018). Compared to CBs, the DCR is a unique risk in IBs that exposes IBs shareholders
to losses, impacting their returns on equity.
Determinants of banks profitability have long been also a major focus of empirical
studies and results of comparative studies dealing with IBs and CBs profitability are divided
(Abedifar et al., 2013; Metwally, 1997; Mokni and Rachdi, 2014; Olson and Zoubi, 2008, 2017;
Yanikkaya et al., 2018). The most common internal factors identified in the literature are the
capital level, the deposits level, the loans ratio, the risk level and banks costs and size.
With regard to the capital level, the financial theories suggest that most leveraged firms
earn higher equity returns. The capital ratio could affect consequently negatively the
profitability. However, a well-capitalized firm has more flexibility to deal with unexpected
losses and could remain consistent profitable in times of crisis. In addition, highly
capitalized firms are able to seize opportunities more effectively thus achieving greater
profitability. Olson and Zoubi (2011) show a negative impact of capital level on the return on
equity. Athanasoglou et al. (2008) and Olson and Zoubi (2011) show that the capital level
impact positively the return assets and the net margin. Berger and Bouwman (2013) reveal
that equity improves the performance of medium and large banks, especially during
banking crises.
The volume of deposits has also an impact on bank profitability. The greater is the
volume of deposits, the greater the bank would be able to expand and diversify its activities
and realize profits. However, this is possible only if the bank is able to convert the deposits
into productive assets. Olson and Zoubi (2011) show that deposits volume affect positively
IBs return on assets. However, Dietrich and Wanzenried (2011) reveal an opposite result.
With regard to loans, a greater dependence upon loans for revenue has generally been
associated with greater profitability (Olson and Zoubi, 2011). The ratio could refer also to
maturity transformation risk. Literature reveals that IBs are increasingly exposed to
maturity transformation risk. IBs have developed commercial capacities for financing
investments that increase the average of assets maturity, but the essential part of
refinancing and deposits remain in short term nature (Hassoune, 2002). This practice
increases the maturity mismatch and poses serious liquidity and asset-liability management
problems that expose IBs to higher liquidity risk.
IMEFM Furthermore, the literature confirm the negative impact of risk, which it induces a
13,1 decline of profitability when the risk value is higher (Athanasoglou et al., 2008; Dietrich
and Wanzenried, 2014; Olson and Zoubi, 2011; Srairi, 2008). With regard to costs ratio, the
ratio is expected to be negatively related to profitability, as improved management of
expenses will increase efficiency, and therefore, raise profits (Athanasoglou et al., 2008;
Dietrich and Wanzenried, 2011; Mokni and Rachdi, 2014). Toumi et al. (2012) argue that
122 the overall costs (informational, agency, transactions, etc.) should be different in IBs
compared to CBs.
Finally, when considering the size, its relationship with profitability is identified as an
important feature in the corporate theories where given the problem of the optimal size that
maximizes firm profitability. The impact of the size diverges between studies. Dietrich and
Wanzenried (2011) find a positive impact for CBs. Bashir (2003) found the same result for
IBs. Larger banks have more possibilities to finance their customers compared to small-
sized banks, increasing, in consequence, their profitability. In addition, larger banks tend to
have more diversified portfolios of banking products compared to small banks reducing
then their risk. Economies of scale can be observed also in the case of larger banks. Other
studies show the opposite result and reveal that size affects negatively the profitability
(Srairi, 2008; Pasiouras and Kosmidou, 2007; Sanusi and Ismail, 2005). Their findings
suggest that if the bank size exceeds a certain level, the profitability tends to decline. This
result is because of the agency costs and other costs related to the management of extremely
large companies.
To examine whether the Islamic finance ethics affect the bank profitability and identify
factors that help to distinguish between the two categories of banks, the following
hypotheses are tested:

H3. Profitability is a good predictor that helps to distinguish between IBs and CBs.
H4. Profitability determinants are good predictors that help to distinguish between IBs
and CBs: H4a. Deposits; H4b. Capital; H4c. Loans; H4d. Insolvency risk; H4e. Credit
risk; H4f. Cost ratio; and H4g. Size.

3. Research design
3.1 Sample and data
Data are compiled mainly from the Bankscope database to construct a list of IBs and CBs.
we keep only listed banks with consolidated financial statements from the Middle East
region. We retain also countries having both IBs and CBs with at least three consecutive
years of data. Our sample covers 98 banks over the period 2006-2014. Banks are categorized
into 45 IBs and 53 CBs. Table I presents sample distribution by bank type and by country.

3.2 Model formulation

The aim of the study is to investigate whether IBs and CBs can be distinguished from one
another on the basis of capital structure, profitability and their determinants. The binary
logistic regression and the linear discriminant analysis are the most widely used
multivariate statistical methods for analyzing categorical outcome variables. While both are
appropriate for the development of linear classification models, the linear discriminant
analysis makes more assumptions about the underlying data (normally distributed
explanatory variables). It is assumed that logistic regression is the more flexible and more
robust method in case of violations of these assumptions (Pohar et al., 2004). We choose to
use this model. The dependent variable is the type of the bank where it takes the value of 1 if
 Bank type
Profitability of
Country CB IB Total banks
Country
Bahrain 4 8 12
Egypt 9 3 12
Iraq 2 2 4
Jordan 6 3 9 123
Kuwait 5 5 10
Lebanon 6 2 8
Palestine 1 2 3
Qatar 3 3 6
Saudi Arabia 3 4 7
Syria 7 2 9
UAE 6 8 14
Yemen 1 3 4 Table I.
Total 53 45 98 Bank type  country

the bank is an Islamic one, 0 otherwise. The binary logistic regression model selects the n
statistically significant variables that help to distinguish between two categories of banks.
The logit probabilities are represented by:

 X
n
ln P1 =ð1
P1 Þ ¼ a þ b j Xj þ « i (1)
j¼1

Where P1 is the probability that a given bank belongs to group 1; a is the constant; b j is the
coefficients of the n-th predictor; and Xj is the predictor variable.

3.3 Variables specification

Table II summarizes the variables mobilized for the comparative analysis of IBs and CBs.
Consistent with prior literature, the profitability variables are represented by the return on
average assets (ROAA) (Athanasoglou et al., 2008; Dietrich and Wanzenried, 2011; Mokni
and Rachdi, 2014; Mollah et al., 2016; Mollah and Zaman, 2015; Olson and Zoubi, 2017); the
return on average equity (ROAE) (Athanasoglou et al., 2008; Dietrich and Wanzenried, 2011;
Mokni and Rachdi, 2014; Mollah and Zaman, 2015; Olson and Zoubi, 2017) and the net
interest margin (NIM) (Dietrich and Wanzenried, 2011; Olson and Zoubi, 2017). The capital
structure is measured by the equity to total assets (CAPITAL) ratio (Beck et al., 2013; Olson
and Zoubi, 2017).

4. Results
4.1 Descriptive statistics
Tables III and IV report, respectively, the descriptive statistics, the t-test of equality of
means and the correlation matrix. All banks variables have been winsorized at the 0.05
and 99.5 per cent percentiles to reduce the influence of outliners and potential data
errors.
Based on the descriptive statistics, the results confirm that IBs are slightly less
profitable than CBs when considered ROAA and ROAE and the related mean values are
significantly different at 1 per cent level. The average return on assets of 1.07 per cent for
IBs is relatively lower compared to CBs (1.6 per cent). Same results are found by Mollah
IMEFM Variables Definitions Sources of data
13,1
Profitability and capital structure variables
CAPITAL Equity to total assets Bankscope
ROAA Return on average assets Bankscope
ROAE Return on average equity Bankscope
NIM Net interest margin: Bankscope
124 For CBs: (interest income-interest expenses)/total gross income
For IBs, net financing income margin = (income generated
from financing activities
income attributable to depositors
and PSIAs holders)/total gross income
Bank-specific variables
Capital structure determinants
MKT_BOOK Market value of assets to book value of assets Bankscope
ROAA Return on average assets Bankscope
COLLATERALS Total securities þ cash and due from banks þ derivatives þ Author’s calculation
lands and buildings þ other tangible assets. For IBs, there are no from Bankscope
conventional derivatives Gropp and Heider (2010)
SIZE Ln (total assets) Bankscope
DIV_PAY Dummy variable that takes the value of one if the bank pays a Bankscope þ
dividend in a given year and zero otherwise primary data from
annual reports
Profitability determinants
DEPOSITS Total customers deposits*to total assets Bankscope
*For CBs: current, saving and term deposits; and for IBs:
Mudharaba and non-Mudharaba based deposits: unrestricted
PSIAs þ Murabaha deposits, medium-term Wakala financing
þ saving accounts þ current accounts
CAPITAL Equity to total assets Bankscope
INSOLVENCY_RISK z-score. The ratio is equal to ROAA þ capital to assets ratio/ Author’s calculation
standard deviation of ROAA over three years (current years from Bankscope
and two previous consecutive years)
CREDIT_RISK Loan loss reserves/gross loans Author’s
Calculation from
Bankscope
LOANS Net loans*/customer deposits and short term funding’s
For IBs, *sales, lease and equity financing contracts (asset
value of Murabaha, Istisna, Ijara, Salam, Musharaka,
Mudharaba, Wakala) Olson and Zoubi (2017)
COST_RATIO Non-interest expenses to gross revenues Bankscope
Non-interest expenses = personal, administrative and other
Table II. overhead expenses
Variables definitions SIZE Ln (total assets) Bankscope

and Zaman (2015), Mollah et al. (2016), Olson and Zoubi (2017) and Kabir et al. (2015). The
return on equity appears to be lower in IBs (8.30 vs 12.59 per cent for CBs) as revealed in
Mollah and Zaman (2015) and Olson and Zoubi (2017) studies. Regarding the CAPITAL
ratio, the comparative analysis confirms the hypothesis that the capital structure of IBs
differ from CBs (17.74 vs 13.29 per cent) and the related mean difference is significant at 1
per cent level. IBs hold a higher proportion of equity as revealed in previous studies (Bitar
and Madiès, 2017; Olson and Zoubi, 2008, 2017). Results show also that IBs holds lower
DEPOSITS (72.3 vs 79.65 per cent) and the mean difference is significant at 1 per cent
level.
 IBs sample CBs sample
Profitability of
Variables N Min Max Mean SD mean mean Two sample t-test banks
NIM 745
2.46 9.19 3.24 1.47 3.34 3.14 1.795*
ROAA 735
8.60 8.99 1.33 1.77 1.07 1.60
4.034***
ROAE 741
49.60 54.58 10.44 10.74 8.30 12.59
5.468***
CAPITAL 761
12.57 86.63 15.51 9.09 17.74 13.29 6.395***
DEPOSITS 747 4.437 94.10 75.97 14.83 72.30 79.65
6.809*** 125
LOANS 742 8.45 203.91 69.81 26.20 78.91 60.71 5.22***
CREDIT_RISK 691 0.003 47.68 6.04 7.97 5.32 6.77
2.36**
INSOLVENCY_RISK 693 2.854 289.01 58.51 52.31 45.62 71.40
4.51***
COLLATERALS 782 7.99 99.48 50.13 18.17 48.42 51.84
2.60***
MKT_BOOK 607 0.12 7.96 1.65 1.08 1.74 1.56 2.01**
COST_RATIO 716 10.08 99.42 46.45 17.23 49.88 43.03 5.304***
Table III.
SIZE 762 10.52 18.71 15.04 1.61 14.75 15.33
4.961***
Descriptive statistics
Notes: ***Significance at 1 per cent level; **significance at 5 per cent level; *significance at 10 per cent and univariate t-test
level for mean differences

Considering the profitability and capital structure determinants, the LAONS ratio is
significantly larger for IBs than for CBs at 1 per cent level of risk (78.91 vs 60.71 per cent). IBs
are better able to convert customer deposits into financing and make more loans than their
conventional peers. The result is in line with Bourkhis and Nabi (2013) study. IBs are also
significantly exposed to lower CREDIT_RISK (5.32 vs 6.77 per cent). Our result is in line with
Abedifar et al. (2013) and Johnes et al. (2014). z-score is significantly lower is IBs suggesting
that they are facing higher INSOLVENCY_RISK and they are in average less sound (45.62 vs
71.40 per cent). Kabir et al. (2015) find the same result contrary to Bourkhis and Nabi (2013).
With regard to the SIZE, IBs are significantly smaller compared to CBs at 1 per cent
level. As the the Islamic banking is a new industry, the result is expected. IBs are
observed with higher costs with 49.88 per cent (43.03 per cent for CBs) indicating a
lower costs efficiency. Previous studies reported the same results (Beck et al., 2013;
Kabir et al., 2015; Mokni and Rachdi, 2014). Furthermore, the value of COLLATERALS
is significantly lower in IBs. Finally, IBs are observed to have in average higher
MKT_BOOK ratio (1.74 vs 1.56 per cent).

4.2 Binary logistic regression results

4.2.1 Comparison of profitability and capital structure: Islamic banks vs conventional banks.
The binary logistic regression on profitability and capital structure variables shows that
NIM, CAPITAL and ROAA appear to be good predictors helping to distinguish between IBs
and CBs while ROAE is not significant. NIM and CAPITAL carry a positive sign and
suggest that the higher these ratios are, the higher is the probability that the bank is Islamic.
ROAA carries a negative sign suggesting that the lower is the return on assets; the higher is
the likelihood that the bank belongs to the category of IBs. Our results are consistent with
the hypotheses of the existence of differences between IBs and CBs in terms of capital
structure and profitability. H1 and H3 are validated.
The results provided in Table V lead to the following explanatory model:


ln P1 =ð1
P1 Þ ¼
1; 716 þ 0; 078 CAPITAL
0; 339 ROAA þ 0; 215 NIM
(2)
 13,1

126

Table IV.
IMEFM

Correlation matrix
Pearson correlation (sig.) NIM ROAA ROAE LOANS CAPITAL CREDIT_RISK DEPOSITS COST_RATIO SIZE COLLATERALS DIV_PAY INSOLVENCY_RISK MKT_BOOK

NIM 1
ROAA 0.30*** 1
ROAE 0.23*** 0.82*** 1
LOANS 0.08 0.23*** 0.04 1
CAPITAL 0.05 0.19***
0.08* 0.24*** 1
CREDIT_RISK
0.20***
0.27***
0.11***
0.32***
0.07* 1
DEPOSITS
0.01
0.14*** 0.05
0.61***
0.65*** 0.07* 1
COST_RATIO
0.03
0.44***
0.43***
0.13***
0.07**
0.003 0.05 1
SIZE
0.01 0.21*** 0.30*** 0.04
0.35***
0.28*** 0.33***
0.38*** 1
COLLATERALS
0.21***
0.20***
0.09**
0.54*** 0.05 0.29*** 0.04 0.22***
0.38*** 1
DIV_PAY 0.12*** 0.19*** 0.20*** 0.09**
0.15***
0.07 0.19***
0.26*** 0.30***
0.04 1
INSOLVENCY_RISK 0.01 0.13*** 0.12***
0.01
0.03
0.13*** 0.02
0.10** 0.21***
0.04 0.212 1
MKT_BOOK 0.15*** 0.20*** 0.25*** 0.07**
0.05
0.17*** 0.16***
0.92*** 0.20***
0.16*** 0.010
0.19*** 1

Notes: ***Significance at 1 per cent level; **significance at 5 per cent level; *significance at 10 per cent level
 95% CI
Profitability of
for Exp(B)j banks
Variables Bd S.Ee Waldf Dfg Sigh Exp(B)i Lower Upper

Step 1a
CAPITAL 0.062 0.011 29.650 1 0.000 1.064 0.062 0.011
Constante
1.255 0.182 47.743 1 0.000 0.285
1.255 0.182
127
Step 2b
ROAA
0.267 0.057 22.079 1 0.000 0.765
0.267 0.057
CAPITAL 0.078 0.013 38.244 1 0.000 1.081 0.078 0.013
Constante
1.111 0.188 34.872 1 0.000 0.329
1.111 0.188
Step 3c
NIM 0.215 0.062 12.027 1 0.001 1.240 0.215 0.062 Table V.
ROAA
0.339 0.063 29.153 1 0.000 0.713
0.339 0.063 Profitability and
CAPITAL 0.078 0.013 38.531 1 0.000 1.082 0.078 0.013 capital structure
Constante
1.716 0.263 42.728 1 0.000 0.180
1.716 0.263 variables retained in
Notes: aVariable introduced in Step 1: CAPITAL; bvariable introduced in Step 2: ROAA; cvariable the logistic
introduced in Step3: NIM; dlogistic coefficient; estandard error of estimate; fWald chi-square ( x 2)values; regression model and
g
degree of freedom; hsignificance; iexponentiated coefficient; j95 per cent confidence interval for Exp(B) their coefficients

The binary logistic regression suggests that the higher the capital ratio is, the higher is the
likelihood that the bank is Islamic. Our result is in line with a recent research of Bitar and
Madiès (2017). The pecking order theory framework, that stimulates that lower information
asymmetries increase a firm’s capital level, gives an explanation to our result. As Toumi
et al. (2012) reported that information asymmetries are theoretically reduced in an Islamic
context, our result is expected. The respect of the fundamental ethical principle of
transparency requirement and the banning of Gharar and the Sharīʿah governance by SSB
that plays an important role in respecting these principles, appear to have an impact on IBs
capital structure. Furthermore, the theoretical development of the agency theory in an
Islamic context by Toumi et al. (2012) reveals that new agency relationships arise in IBs, and
thus, would impact their capital structure. Toumi et al. (2012) argue that the agency
problems between managers and PSIAs holders promote the equity in IBs. The additional
agency costs related to this relationship are associated to the control exercised by
shareholders and the SSB to safeguard the interests of PSIA holders, as the later have no
right to intervene in the management of their funds as shareholders can do. The agency
costs associated to managers-PSIAs holders’ relationship are at the initiative of the
managers to demonstrate the proper management of funds of PSIA holders. The importance
of agency costs associated to this relationship makes the equity financing less expensive.
Although IBs are observed to hold more equity, we find that they appear to be less
profitable when the return on assets is considered. Our result is similar to Mollah and
Zaman (2015), Mollah et al. (2016), Olson and Zoubi (2017) and Kabir et al. (2015) but
different from that of Bitar and Madiès (2017), who reveal that the higher the profitability,
the greater the likelihood that a bank is Islamic. IBs are not allowed to engage in speculative
activities and derivatives trading; so IBs portfolio risk is thus theoretically lower when
comparing to CBs portfolio, which directly affects their return on assets. In addition, the
lower deposits ratios in IBs as reveal our results prevent these institutions to expand and
diversify their activities and realize more profits compared to CBs. Olson and Zoubi (2011)
found a positive association between the volume of deposits and the return on assets. Costs
IMEFM ratio is also observed to be higher in IBs as reveal our results. Toumi et al. (2012) argue that
13,1 the overall costs in IBs; informational, agency and transactional; should be different in IBs
compared to CBs. This feature would impact negatively IBs profitability. Furthermore, NIM
appears as the third good predictor predicting the membership to IBs groups. Our results
show that the higher the NIM, the greater the likelihood that a bank is Islamic. The
difference in average between the income-generating from financing activities (interest
128 income for CBs) and the income attributable to depositors and PSIAs holders (interest
expenses for CBs) is higher in IBs and it could explain our result. The profit and loss sharing
with PSIAs holders could reduce the financing expenses for IBs increasing also the net
margin for IBs.
4.2.2 Comparison of determinants of profitability and capital structure: Islamic banks vs
conventional banks. The binary logistic regression on banks’ capital structure determinants
show that COLLATERALS, DIV_PAY and SIZE are the best predictors that help to
distinguish between IBs and CBs. COLLATERALS and SIZE carry negative signs suggesting
that the lower these measures are; the higher is the likelihood that the bank belongs to the
category of IBs. However, DIV_PAY carry a positive sign revealing that IBs tend to distribute
more dividends to their shareholders. The Hypotheses H2b, H2c and H2d are validated.
The results provided in Table VI lead to the following explanatory model:


ln P1 =ð1
P1 Þ ¼ 4; 776
0; 19 COLLATERALS þ 0:904 DIV_PAY
0; 163 SIZE
(3)

Our result put in evidence that banks having a more generous dividend distribution policy,
lower collaterals and smaller size tend to have more capital and belongs to the category of
IBs. These results are consistent with the theoretical and empirical literature.
IBs tend to distribute a higher dividend to shareholders. We note that the informational role
of the dividend is widely studied in financial theories, which put in evidence that dividends

95% CI
for Exp(B) j
Variables Bd S.Ee Waldf Dfg Sigh Exp(B)i Lower Upper

Step 1a
COLLATERALS
0.028 0.007 17.797 1 0.000 0.972
0.028 0.007
Constante 0.739 0.314 5.555 1 0.018 2.095 0.739 0.314
Step 2b
COLLATERALS
0.030 0.007 18.439 1 0.000 0.971
0.030 0.007
DIV_PAY
1.139 0.282 16.310 1 0.000 0.320
1.139 0.282
Constante 1.761 0.419 17.676 1 0.000 5.819 1.761 0.419
Step 3c
Table VI. COLLATERALS
0.190 0.083 5.282 1 0.022 0.827
0.190 0.083
Capital structure DIV_PAY
0.904 0.298 9.214 1 0.002 0.405
0.904 0.298
determinants SIZE
0.163 0.081 3.991 1 0.046 0.850 0.724 0.997
retained in the Constante 4.776 1.385 11.882 1 0.001 118.606 4.776 1.385
logistic regression Notes: aVariable introduced in Step 1: COLLATERALS; bvariable introduced in Step 2: DIV_PAY;
model and their c
variable introduced in Step3: SIZE; dlogistic coefficient; estandard error of estimate; fWald x 2 values;
g
coefficients degree of freedom; hsignificance; iexponentiated coefficient; j95 per cent confidence interval for Exp(B)
provide a good signal on the future prospects of the bank, promoting the issuance of more Profitability of
equity (Gropp and Heider, 2010). Financial firms that distribute dividends have on average a banks
higher level of capital and our results concur this finding. This positive relationship is verified
by empirical studies of Octavia and Brown (2010) and Frank and Goyal (2009).
Results reveal also that IBs tend to hold a lower proportion of COLLATERALS
compared to CBs. As we used in our study the measure of Gropp and Heider (2010) to assess
COLLATERALS (Table II), this result is expected. As the access to conventional derivatives
is banned, the investment in securities is limited to Sharīʿah-compliant securities and the
129
interbank operations are not well developed in IBs, the values of COLLATERALS tend to be
lower in IBs. Following the trade-off theory arguments, collaterals and tangibility of assets
tends to decrease equity (Aggarwal and Jamdee, 2003; Frank and Goyal, 2009; Rajan and
Zingales, 1995). Firms with a high proportion of collaterals help firms to raise more debts
secured by these assets. Bitar et al. (2018) find a different result for IBs that collaterals
increase equity.
Furthermore, our results reveal that IBs tend to have lower SIZE. Our result is consistent
with the empirical literature, which reveal that SIZE is negatively associated to equity
(Abedifar et al., 2013; Aggarwal and Jamdee, 2003; Beck et al., 2013; Bitar et al., 2018; Booth
et al., 2001; Diamond and Rajan, 2000; Titman and Wessels, 1988). Gropp and Heider (2010)
and Octavia and Brown (2010) confirm this negative association for CBs. Bitar et al. (2018)
find the same result for IBs. The bankruptcy and insolvency risks are reduced in larger
firms, as the business diversification reduces the volatility of cash flows encouraging them
to look for external funds and debts easily in financial markets.
Regarding the other bank capital structure determinants, they appear to not be
statistically significant showing that they do not represent good predictors helping to
distinguish between IBs and CBs.
The binary logistic regression on banks profitability determinants show that LOANS,
CREDIT_RISK, INSOLVENCY_RISK and COST_RATIO appear to be the best predictors
that help to distinguish between IBs and CBs. CREDIT_RISK and INSOLVENCY_RISK
carry negative signs suggesting that the lower these measures are; the higher is the
likelihood that the bank is Islamic. However, LOANS and COST_RATIO carry positive
signs revealing that IBs tend to have a higher liquidity ratio and to be less efficient. The
Hypotheses H4c, H4d, H4e and H4f are validated.
The results provided in Table VII lead to the following explanatory model:


ln P1 =ð1
P1 Þ ¼
2; 082 þ 0; 012 LOANS
0:091 CREDIT_RISK

0; 006 INSOLVENCY_RISK þ 0; 031 COST_RATIO (4)

The signs affected to each variable put in evidence that banks with higher LOANS ratio,
higher INSOLVENCY_RISK, lower CREDIT_RISK and higher COST_RATIO tend to be
less profitable (when ROAA is considered) or more profitable (when NIM is considered) and
belongs to the category of IBs. Our results are consistent with the previous theoretical and
empirical literature.
First, IBs tend to hold higher net financing to customers’ deposits ratio in IBs (LOANS
ratio). The result reveals that IBs benefit more from the intermediation activity and convert
easily the deposits into financing operations, which increase their net margin compared to
CBs. A large volume of LOANS operations would increase the bank profitability. This
positive relationship is already verified by empirical studies (Bashir, 2003; Olson and Zoubi,
2011; Pasiouras and Kosmidou, 2007; Sanusi and Ismail, 2005; Srairi, 2008).
IMEFM 95% CI
13,1 for Exp(B)k
Variables Be S.Ef Waldg Dfh Sigi Exp(B)j Lower Upper

Step 1a
COST_RATIO 0.027 0.006 23.743 1 0.000 1.027 0.027 0.006
Constante
1.834 0.276 44.024 1 0.000 0.160
1.834 0.276
130
Step 2b
LOANS 0.017 0.004 17.690 1 0.000 1.017 0.017 0.004
COST_RATIO 0.032 0.006 30.695 1 0.000 1.033 0.032 0.006
Constante
3.205 0.436 53.963 1 0.000 0.041
3.205 0.436
Step 3c
LOANS 0.018 0.004 18.967 1 0.000 1.018 0.018 0.004
COST_RATIO 0.031 0.006 26.937 1 0.000 1.031 0.031 0.006
INSOLVENCY_RISK
0.005 0.001 11.249 1 0.001 0.995
0.005 0.001
Constante
2.867 0.446 41.394 1 0.000 0.057
2.867 0.446
Step 4d
LOANS 0.012 0.004 9.135 1 0.003 1.013 0.012 0.004
CREDIT_RISK
0.091 0.026 12.300 1 0.000 0.913
0.091 0.026
Table VII. COST_RATIO 0.031 0.006 26.546 1 0.000 1.032 0.031 0.006
Profitability INSOLVENCY_RISK
0.006 0.002 13.215 1 0.000 0.994
0.006 0.002
determinants Constante
2.082 0.482 18.647 1 0.000 0.125
2.082 0.482
retained in the
Notes: aVariable introduced in Step 1: COST_RATIO; bvariable introduced in Step 2: LOANS; cvariable
logistic regression introduced in Step3: INSOLVENCY_RISK; dvariable introduced in Step4: CREDIT_RISK; elogistic
model and their coefficient; fstandard error of estimate; gWald x 2 values; gdegree of freedom; isignificance; jexponentiated
coefficients coefficient: 95 per cent confidence interval for Exp(B)

Furthermore, our results put in evidence that IBs tend to be less efficient with having higher
COST_RATIO than CBs. Previous studies report the same result (Beck et al., 2013; Kabir et al.,
2015; Mokni and Rachdi, 2014). The literature reports that costs are negatively associated to
profitability (Athanasoglou et al., 2008; Dietrich and Wanzenried, 2011; Mokni and Rachdi,
2014) explaining the lower profitability (ROAA) in IBs compared to CBs. Toumi et al. (2012)
argue that the overall costs should be different in IBs compared to CBs. As a result of the
original governance structure and the Sharīʿah governance in IBs, new agency costs emerge in
the new context increasing in consequence costs in IBs. Overheads should be higher also in IBs
because of the involvement of the SSB members in the governance system of the bank. The
transactional costs related to the Islamic financial transactions could be more important also
than the classic credit operations, as several stakeholders are involved. Furthermore, our
results reveal that IBs tend to be exposed to lower credit risk indicating a better assets quality
in IBs. Beck et al. (2013) and Kabir et al. (2015) found the same result. One of the fundamental
Islamic ethical principles is the requirement of money traceability that requires the backing of
the financial transactions to real and tangible assets. This feature implies that IBs are actively
involved in the real economy. The credit portfolios are more secured, which allow IBs to control
their credit risk exposure reducing strongly the bankruptcy costs. Furthermore, Toumi et al.
(2012) report that information asymmetries are lower in an Islamic finance context. Kabir et al.
(2015) argue that in a low information asymmetry environment, the bank is exposed to a low
level of credit risk. Abedifar et al. (2013) add that the religiosity beliefs of IBs customers may
induce loyalty and decrease default, which in consequence reduces their credit risk compared to
CBs.
 Additionally, our results put in evidence that IBs tend to have lower z-score revealing Profitability of
higher exposure to insolvency risk compared to CBs. To investigate further the reasons for banks
higher instability in IBs, we consider the components of the z-score, namely, ROAA, the
equity ratio and the standard deviation of ROAA. The return on asset is slightly lower in
IBs in the sampled period. However, IBs have a significantly higher equity ratio. The result
reveals a higher standard deviation of the return on assets in IBs. This implies higher
earnings volatility in IBs resulting in a lower z-score. Kabir et al. (2015) speculate different 131
reasons. First, IBs are relatively smaller banks with a shorter history of operations and with
a lack of managerial skills needed to appropriate investment strategies compared to CBs.
Second, the Shariah complexity in Islamic financial products may also create an obstacle to
proper portfolio investment and diversification. High earnings volatility could result from
the large exposures of IBs to the real estate and construction industries that faced significant
declines in profitability in 2009 in the Middle East region.

5. Conclusion
The purpose of this paper is to identify factors related to capital structure and profitability
that could discriminate IBs form CBs. We investigate whether IBs and CBs can be
distinguished from one another on the basis of their capital structure, profitability and their
respective classical determinants. Our paper provides a comparative study based on a
predictive model, the binary logistic regression, using a sample of 53 listed CBs and 45 listed
IBs from the Middle East region and for the period 2006-2014. Results offer a confirmation
that Islamic finance ethics influence IBs profitability and the level of capital compared to
CBs. Results of the binary logistic regression on profitability and capital structure variables
show that the net margin, the return on asset and the capital ratio are good predictors that
help to distinguish between IBs and CBs while the return on equity is not significant.
Furthermore, with regard to results on capital structure determinants, collaterals, dividend
policy and size are observed to be the best predictors that help to distinguish between the
two types of banks. Results regarding profitability determinants reveal that loans ratio,
credit risk, insolvency risk and cost ratio appear as the best predictors.
The study contributes to the scare literature dedicated to the use of the multivariate
statistical methods for the analysis of data to compare the financial characteristics of IBs
and CBs. Our results help to understand the differences between IBs and CBs to understand
how following Islamic finance ethics and being under Sharīʿah governance could impact
bank financial characteristics. The paper shall not only provide practical implications for
bank managers but also illuminates some perspectives to the policymakers who set rules to
ensure the financial stability in the financial system where the IBs and CBs operate together.
Our results help also to understand factors affecting financial decisions in IBs. If in
conventional finance, the standard presiding decisions of an economic agent is optimizing
the risk-return ratio, this standard is not the only or the primary decision criterion in the
Islamic finance context where spiritual and theological considerations are taken into
consideration. For future research, the research could expand analysis and explore other
differences with using the same method.

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Corresponding author
Kaouther Toumi can be contacted at: kaouther.toumi@iut-tlse3.fr

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