International Review of Economics and Finance xxx (xxxx) xxx

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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

What determines the profitability of Islamic banks: Lending or fee?

A.S.M. Sohel Azad a, *, Saad Azmat b, Aziz Hayat a
a
Department of Finance, Deakin Business School, Faculty of Business and Law, Deakin University, 221 Burwood Highway, Burwood, Vic, 3125,
Australia
b
Suleman Dawood School of Business, Lahore University of Management Sciences, Sector U, DHA, Lahore Cantt, 54792, Pakistan

A R T I C L E I N F O A B S T R A C T

JEL classification: This paper analyses the effect of bank lending and fee income on Islamic and conventional bank's
G14 performance. The paper builds a theoretical model and provides empirical evidence to show that
G21 Islamic banks as compared to conventional banks can have a greater reliance on fee-based income
G24
than returns from loans to increase their profitability. Using data from a sample of 20 countries for
Keywords: the period from 2000 to 2015 for Islamic and conventional banks, we find that the bank fee is an
Islamic bank
important determinant of the profitability of an Islamic bank. Interestingly, many commonly used
Conventional bank
measures such as loan to deposit ratio do not affect the Islamic banks' profitability as much as they
Loan to deposit ratio
Fee do for conventional banks. Our findings imply that Islamic banks' lower sensitivity to loan to
Religiosity deposit ratio may contribute to lower credit risk. However, an over-reliance on fee-based income
Performance may affect their growth, profitability and sustainability in the long run.

1. Introduction

Islamic banking literature has grown rapidly in the last decade, fuelled by the success of the Islamic finance industry. The existing
literature has examined different aspects of the industry including risk, performance, efficiency and stability of Islamic banking in
contrast to conventional banking (see Abedifar, Molyneux & Tarazi, 2013; Beck, Demigruc-Kunt & Merrouche, 2013; Abedifar et al.,
2015 and Hassan & Aliyu, 2018).1 In spite of the surge in the literature, there are still some puzzling issues on the determinants, which
may affect Islamic banking performance differently from conventional banks. In this paper, we offer theoretical and empirical evidence
that there are two determinants, in particular, fee income2 and loan to deposit ratio,3 which may affect Islamic and conventional banks
differently.
Several prior studies on conventional banks find the importance of fee income to bank profitability (see, for instance, Demirgüç-Kunt
& Huizinga, 1999; Stiroh, 2004; Lepetit, Nys, Rous, & Tarazi, 2008 and Maudos & Solís, 2009). Demirgüç-Kunt and Huizinga (1999)

* Corresponding author.
E-mail addresses: s.azad@deakin.edu.au (A.S.M.S. Azad), saad.azmat@lums.edu.pk (S. Azmat), aziz.hayat@deakin.edu.au (A. Hayat).
1
In particular, Hassan and Aliyu (2018) summarize that while Islamic banks are less susceptible to a systemic crisis, Islamic banks usually perform
below their conventional counterpart.
2
Regarding the fee, there are two alternative ways Islamic banks perform their lending activities, by involving an asset such that it is a buy-sell or a
lease arrangement. In case if they cannot involve an asset, they charge a fee for their services. Hence, charging a fee is an essential part of the Islamic
bank's businesses for reasons of Shariah compliance.
3
We have used the term “lending” or “loans” for the asset side financing of Islamic banks. Technically these are not loans as Islamic banks involve
an asset when structuring these transactions. However, to be consistent with the literature, we have used the terms “loans” and “lending” in this
paper.

https://doi.org/10.1016/j.iref.2019.05.015
Received 15 August 2018; Received in revised form 29 May 2019; Accepted 30 May 2019
Available online xxxx
1059-0560/© 2019 Elsevier Inc. All rights reserved.

Please cite this article as: Azad, A. S. M. S. et al., What determines the profitability of Islamic banks: Lending or fee?, International
Review of Economics and Finance, https://doi.org/10.1016/j.iref.2019.05.015
A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Fig. 1. Market power of Islamic and conventional bank. This figure shows the market power for Islamic (IB) and conventional (CB) banks for the
period from 2000 to 2015. Market power is estimated using the Lerner index.

Fig. 2. Lending to deposit ratio: Islamic vs conventional bank. This figure shows the lending to deposit ratio for Islamic bank (IB) and con-
ventional (CB) banks for the period from 2000 to 2016.

Fig. 3. Piety premium. This figure shows the piety premium, calculated as the difference of net interest spread (interest/profit rate on lending minus
interest/profit rate on customer deposit) between Islamic and conventional banks based on (the) cross-sectional average for the given year(s).

present the empirical evidence that banks in Eastern Europe relied heavily on fee-based operations in the early stages of their growth.
Lepetit et al. (2008) report that in the 1980s, the US commercial banks' share of fee-based income represented 19% of total income,
which had increased to as much as 43% in 2001 (Stiroh, 2004). Recently Ariss (2010), Beck, Demigruc-Kunt and Merrouche (2013) and
Bourkhis and Nabi (2013) have compared fee income and loan to deposit ratio for Islamic banks vis-a-vis conventional banks.4 However,
these studies have not thoroughly examined how fee-based income and loan to deposit ratio may affect the performance, profitability
and risk of Islamic banks. We fill this research gap by examining the role of fee-based income as well as loans to deposit ratio on banks’
profitability after controlling for the market power and other bank-specific and macroeconomic variables.
Why fee-based income and loan to deposit ratio may affect Islamic banks differently requires further explanation. We argue that, as
there are significant restrictions on the kind of lending arrangement an Islamic bank can use, they may have to rely on non-interest based
arrangements involving fee income that complies with Islamic law. This should mean that every unit increase in fee income is expected
to contribute more to an Islamic bank's profitability than that of a conventional bank. Moreover, given the limited number of asset side
products that are available for dispersing the excess liquidity of Islamic banks, it may be that an increase in lending may put downward

4
These studies find that loan to deposit ratio is significantly higher for Islamic banks than the conventional banks, while fee income is lower for
Islamic banks as compared to conventional banks. Our sample results are aligned to these findings.

2
A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 1
Summary statistics. This table presents the descriptive statistics of Islamic and conventional banks. Net interest margin (NIM) and interest expense
margin (IEM) are dependent variables, while Loan-to-Deposit Ratio (LDR) and fee are the key independent variables. Others are control variables. All
variables are in percentage except Lerner index and Total Asset. Lerner index takes a value between 0 and 1. Total Assets are in US$ (thousands).
Results are based on annual data on CBs and IBs from 20 Muslim countries for the period from 2000 to 2015.
Variable Islamic Bank (N ¼ 608) Conventional Bank (N ¼ 1991)

Mean SD Min Max Mean SD Min Max

NIM 3.00 29.00 110.00 63.90 1.00 9.00 148 23

IEM 4.00 4.00 0.02 80.00 4.00 3.00 0 50
Loan-to-deposit ratio (LDR) 104.64 79.80 16.06 640.82 85.99 33.18 14.11 250.4
Fee 1.00 1.00 0.00 12.00 1.00 1.00 0.00 5.00
Lerner 0.22 0.19 0.03 0.75 0.14 0.18 0 0.98
DAR (deposit to asset ratio) 66 21 0 92 69 15 0 94
Operating cost (OC) 2.80 0.03 0.52 42.90 2.6 1.5 0.1 12.7
Credit Risk (CR) 6.07 7.91 0.00 61.02 7.166 10.159 0 98.63
Risk Aversion (RA) 16.22 14.14 2.51 91.27 12.429 6.965 0.55 78.97
Total Asset (TA) 6,546,508 11,100,000 17,211.03 84,200,000 9,771,417 17,000,000 106.09 134,000,000
Non interest margin (NII) 1 3.1 40.1 12.4 1 1.6 12 14.8
Opportunity cost (OPC) 10.3 9.2 0 51.4 8.9 8.5 0 84.6
Efficiency 56.402 40.264 184.25 503.45 53.742 38.836 850.79 790.76

Market volatility 0.38 0.13 0 0.74 0.42 0.11 0 0.74

GDP_Gr 4.42 3.84 15.088 26.17 4.84 3.1 15.088 26.17
Inflation 7.8 10.51 26.808 52.851 6.71 6.95 26.808 36.67

pressure on Islamic bank's profitability. Hence, in comparison to conventional banks, an increase in loan to deposit may be a less
important determinant of profitability for an Islamic bank.
By emphasising loan to deposit ratio and fee-based income, we re-visit some puzzling issues of market power, piety premium,
religiosity, risks and profitability in Islamic banking in comparison to its conventional counterparts. These aspects are important to
investigate for a variety of reasons. First, while previous research (e.g., Abedifar et al., 2013) finds no evidence of piety premium, a
recent study by Azad, Azmat, Chazi, and Ahsan (2018) detects that a piety premium is charged by Islamic banks. The argument to the
piety premium is that Islamic banks bear higher risks than conventional banks because of lower economies of scale and Shariah
compliance costs (Beck, Demirgüç-Kunt, & Merrouche, 2013). In this paper, we examine if, in the presence of a piety premium, Islamic
banks’ higher lending to deposit ratio could affect its profitability.
Second, for about a decade beginning 2000, Islamic banks enjoyed a higher market power (measured by the Lerner Index, see Fig. 1)
than their conventional counterparts as well as a piety premium for all the years since 2006, except for 2015 (see Fig. 3). During the same
period, Islamic banks flourished at a rapid pace, growing at about 15%–20% per annum. Both the demand and supply side factors have
contributed to the industry's growth, along with the increasing market power of Islamic banks. Particularly, the share of Islamic banks
has increased because of the Shariah consciousness of its customers. Subsequently, loan to deposit ratio of Islamic banks have expe-
rienced a substantial increase compared to their conventional counterparts (see Fig. 2) in an environment fraught with higher market
power, positive piety premium and lower loan defaults (e.g., Azad et al., 2018; Baele, Farooq, & Ongena, 2014). We argue in this paper
that this increase in loan to deposit ratio may not have a significant impact on the performance of Islamic banks as it is found for
conventional banks. This is due to their inefficiency (Beck, Demigruc-Kunt & Merrouche, 2013) or their inability to convert deposits into
profitable lending because of religious constraints (Azmat, Skully, & Brown, 2015). In this paper, we find that both may be true.
Moreover, Islamic banks might have adopted an alternative avenue, such as enhancing the fee-based income to improve the profit-
ability, similar to the banks in Eastern Europe and the US as mentioned above. Hence, it is imperative to examine whether fee-based
income improves Islamic banks' profitability.
Our theoretical and empirical settings proceed as follows. First, we build a theoretical model of Islamic bank intermediation, where
the bank is taking funds from its religious customers who may experience some additional utility from depositing in an Islamic bank.5
We show that the optimal deposit rate offered by the Islamic bank depends on several factors including bank's risk, market power,
macroeconomic risk and the customer's religiosity. Then the behaviour of customers on the asset side is examined. We assume that the
customers can either borrow or be involved in a fee-based arrangement, both of which have to be compliant with Islamic finance law. An
optimal rate of return on Islamic bank loans is then shown on the assumption of asymmetric information (hence, higher risk) and varied
borrower qualities. We compute the Islamic bank's profitability function and demonstrate how the loan to deposit ratio may affect the
bank's overall profitability. Our model shows that Islamic banks are most secured if they operate in an environment where there are a
large number of quality religious borrowers and in an environment fraught with risk and information asymmetry, they are better off

5
In a conventional banking set up, the banking theory of Diamond and Rajan (2000, 2001) implies the discipline imposed by depositors mitigates
risky bank lending. The risk-sharing feature of Islamic banking deposits brings a similar result on lending. However, this can also bring an ambiguous
outcome on lending performance because of their loyalty towards Islamic banking and risk averse attitude (Abedifar et al., 2013).

3
 A.S.M.S. Azad et al.
Table 2
Correlation matrix: Islamic bank. This table presents the Pearson correlations between dependent variables and independent variables for Islamic banks. Results are based on annual data of 608 bank-year
observations from 20 Muslim countries for the period from 2000 to 2015. Note: dark-fonts represent correlation significantly different from zero and *p < 0.1; **p < 0.05; ***p < 0.01.

Fee

LogðTotalassetsÞ
Creditrisk
Deposit  to  assetratio

Riskaversion

Non  interestincome
Netinterestmargin

Loan  to  depositratio
Interestexpensemargin

Efficiency

Marketvolatility
Lerner

Operatingcost

Opportunitycost
 

Net interest margin

4

Interest expense margin 0.043

Loan-to-deposit ratio 0.151*** 0.184***
Lerner 0.089 0.394*** 0.013
Fee 0.134** 0.176*** 0.027 0.230***
Deposit-to-asset ratio 0.052 0.011 0.741*** 0.093* 0.065
Efficiency 0.053 0.216*** 0.000 0.133** 0.096* 0.079
Operating cost 0.216*** 0.413*** 0.007 0.315*** 0.259*** 0.069 0.635***
Credit risk 0.356*** 0.230*** 0.018 0.123** 0.057 0.043 0.189*** 0.133**

International Review of Economics and Finance xxx (xxxx) xxx

Risk aversion 0.177*** 0.048 0.338*** 0.157*** 0.080 0.589*** 0.106* 0.097* 0.048
Log(Total assets) 0.072 0.473*** 0.063 0.095* 0.018 0.023 0.433*** 0.436*** 0.125** 0.132**
Non-interest income 0.094* 0.225*** 0.076 0.130** 0.418*** 0.127** 0.652*** 0.651*** 0.149** 0.070 0.385***
Opportunity cost 0.108* 0.212*** 0.213*** 0.207*** 0.142** 0.109* 0.012 0.246*** 0.067 0.263*** 0.052 0.072
Market volatility 0.014 0.391*** 0.011 0.543*** 0.347*** 0.134** 0.178*** 0.391*** 0.171*** 0.060 0.144** 0.138** 0.034
 A.S.M.S. Azad et al.
Table 3
Correlation matrix: Conventional bank. This table presents the Pearson correlations between dependent variables and independent variables for conventional banks. Results are based on annual data of
1991 bank-year observations from 20 Muslim countries for the period from 2000 to 2015. Note: dark-fonts represent correlation significantly different from zero and *p < 0.1; **p < 0.05; ***p < 0.01.

LogðTotalassetsÞ
Loan  to  depositratio

Fee

Creditrisk
Deposit  to  assetratio

Riskaversion

Non  interestincome
Netinterestmargin

Interestexpensemargin

Efficiency

Marketvolatility
Lerner

Operatingcost

Opportunitycost
Net interest margin
Interest expense 0.115***
5

income margin
Loan-to-deposit ratio 0.314*** 0.001
Lerner 0.008 0.505*** 0.070**
Fee 0.219*** 0.092*** 0.100*** 0.154***
Deposit-to-asset ratio 0.116*** 0.107*** 0.565*** 0.111*** 0.011
Efficiency 0.046 0.299*** 0.045 0.145*** 0.090*** 0.033
Operating cost 0.221*** 0.513*** 0.004 0.422*** 0.342*** 0.119*** 0.414***

International Review of Economics and Finance xxx (xxxx) xxx

Credit risk 0.077** 0.086*** 0.019 0.035 0.071** 0.068** 0.209*** 0.100***
Risk aversion 0.116*** 0.180*** 0.239*** 0.133*** 0.028 0.406*** 0.062** 0.076** 0.209***
Log(Total assets) 0.013 0.324*** 0.020 0.133*** 0.082*** 0.004 0.286*** 0.389*** 0.214*** 0.248***
Non-interest income 0.161*** 0.422*** 0.020 0.314*** 0.127*** 0.143*** 0.469*** 0.746*** 0.015 0.047 0.316***
Opportunity cost 0.205*** 0.203*** 0.216*** 0.252*** 0.119*** 0.109*** 0.002 0.143*** 0.075** 0.027 0.012 0.077**
Market volatility 0.021 0.405*** 0.017 0.394*** 0.237*** 0.103*** 0.086*** 0.348*** 0.012 0.078** 0.091*** 0.181*** 0.105***
A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 4
Net interest margin (NIM) and the loan to deposit ratio and the bank fee. This table presents regression results of equation (13). M1 shows the
empirical results based on the influence of loan to deposit ratio only, while M2 presents the results with both loan to deposit ratio and fee-based income
on the profitability measure (NIM) of the bank. *, ** and *** indicate the significance of t-tests at 10%, 5% and 1%, respectively. In parentheses are the
standard errors, which are robust to heteroscedasticity and serial (cross-sectional) correlation.
Variables of interest Dependent variable: Net interest margin

Full sample Conventional bank Islamic bank

M1 M2 M1 M2 M1 M2

Loan-to-deposit ratio 0.0001*** 0.0001** 0.001*** 0.001*** 0.00000 0.00002

(0.0001) (0.0001) (0.0002) (0.0002) (0.00002) (0.00001)
Fee – 0.610** – 0.708 – 0.694***
– (0.307) – (0.535) – (0.251)

Controls

Lerner 0.111*** 0.128*** 0.134*** 0.143*** 0.046*** 0.064***

(0.031) (0.035) (0.045) (0.047) (0.015) (0.011)
Deposit-to-asset ratio 0.049* 0.047* 0.105*** 0.108*** 0.003 0.013
(0.026) (0.026) (0.038) (0.04) (0.012) (0.011)
Efficiency 0.00001 0.0000 0.00001 0.0000 0.0001** 0.0002***
(0.0001) (0.0001) (0.00004) (0.00004) (0.00005) (0.00004)
Operating cost 0.477* 0.213 0.491 0.299 0.788*** 0.363
(0.243) (0.271) (0.300) (0.271) (0.297) (0.373)
Credit risk 0.001** 0.001** 0.0005* 0.0005* 0.0001 0.0002
(0.0002) (0.0002) (0.0003) (0.0002) (0.0002) (0.0003)
Risk aversion 0.001*** 0.001*** 0.001*** 0.002*** 0.001** 0.001**
(0.0003) (0.0003) (0.0004) (0.0004) (0.0003) (0.0003)
Log(Total assets) 0.0002 0.001 0.002 0.003 0.006 0.009
(0.005) (0.005) (0.006) (0.006) (0.007) (0.007)
Non-interest income 0.23 0.449** 0.23 0.344 0.322** 0.822***
(0.153) (0.204) (0.217) (0.228) (0.15) (0.247)
Opportunity cost 0.012 0.006 0.009 0.009 0.002 0.012
(0.044) (0.046) (0.057) (0.057) (0.018) (0.017)
Market volatility 0.003 0.013 0.014 0.02 0.0001 0.018
(0.018) (0.018) (0.023) (0.023) (0.018) (0.015)

Firm fixed effect Yes Yes Yes Yes Yes Yes

Year fixed effect Yes Yes Yes Yes Yes Yes
Observations 2239 2185 1746 1714 493 471
R2 0.082 0.09 0.108 0.113 0.215 0.283

using fee-based transactions to improve their profitability.6

We examine our theoretical propositions using the annual data from a sample of 20 countries for the period from 2000 to 2015 for
Islamic and conventional banks. Controlling for firm and year fixed effects, we find, in line with our hypotheses, that for Islamic banks,
there exists an insignificant and (or negatively significant) relationship between loan to deposit ratio (LDR) and net interest income
margin (NIM).
In contrast, we find that the loan to deposit ratio is a significantly positive determinant of conventional bank's NIM. When we test for
the impact of LDR on another performance measure, namely interest expense margin (IEM), we find that LDR positively affects the
Islamic bank's IEM and negatively affects conventional bank's IEM. We then test for the impact of fee-based income on Islamic and
conventional bank's profitability. In line with our theoretical model, we find that the fee-based income has a significantly positive impact
on the profitability of Islamic bank (NIM), while the effect is insignificant for conventional banks. Lastly, we test the sensitivity of fee and
LDR relationships with IEM/NIM during the periods when Islamic banks enjoyed greater market power, positive piety premium and
higher loan to deposit ratio. Results remain the same and are robust to various sub-sample analyses as well as to alternative econometric
specifications. We thus contribute to the literature on the determinants of the Islamic bank's profitability by offering theoretical and
empirical insights into how loan to deposit ratio and fee income may affect the profitability of Islamic and conventional banks
differently.
Our findings have important implications for Islamic banks and regulator. We suggest that Islamic banks should improve their
liquidity management by designing new financing products on the asset side as the over-reliance on fee-based income may threaten their
long-term profitability and stability. For regulators, our results suggest that Islamic banks can be less risky and more stable than con-
ventional banks as they are less sensitive to changes in the loan to deposit ratio.
The rest of the paper is structured as follows. Section 2 discusses the model. The data and methodology are described in Section 3.
Section 4 discusses the results. Section 5 concludes the paper.

6
Cantrell and Yust (2018) find that religiosity is associated with larger fees earned from additional banking services.

6
A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 5
Interest expense margin (IEM) and the loan to deposit ratio and the bank fee. This table presents regression results of equation (13). M1 shows the
empirical results based on the influence of loan to deposit ratio only, while M2 presents the results with both loan to deposit ratio and fee-based income
on the profitability measure (IEM) of the bank. *, ** and *** indicate the significance of t-tests at 10%, 5% and 1%, respectively. In parentheses are the
standard errors, which are robust to heteroscedasticity and serial (cross-sectional) correlation.
Variables of interest Dependent variable: Interest expense margin

Full-sample Conventional-bank Islamic-bank

M1 M2 M1 M2 M1 M2

Loan-to-deposit ratio 0.00004 0.00004 0.0001* 0.0001* 0.0001* 0.0001**

(0.0001) (0.0001) (0.0001) (0.0001) (0.00005) (0.00004)
Fee – 0.141 – 0.223 – 0.164
– (0.137) – (0.242) – (0.115)

Controls

Lerner 0.011** 0.013** 0.018*** 0.020*** 0.001 0.003

(0.005) (0.006) (0.005) (0.005) (0.007) (0.011)
Deposit-to-asset ratio 0.003 0.003 0.021 0.022 0.042*** 0.036***
(0.014) (0.015) (0.018) (0.018) (0.014) (0.012)
Efficiency 0.00001 0.00001 0.000 0.00001 0.00003 0.0001
(0.00001) (0.00001) (0.00001) (0.00001) (0.0001) (0.0001)
Operating cost 0.318*** 0.264* 0.398*** 0.342** 0.09 0.05
(0.118) (0.143) (0.124) (0.155) (0.263) (0.35)
Credit risk 0.0004** 0.0004** 0.0002* 0.0002* 0.001*** 0.001***
(0.0002) (0.0002) (0.0001) (0.0001) (0.0001) (0.0003)
Risk aversion 0.00002 0.0001 0.0001 0.0001 0.001** 0.001**
(0.0002) (0.0002) (0.0002) (0.0002) (0.0002) (0.0003)
Log(Total assets) 0.007*** 0.008*** 0.006*** 0.007*** 0.008*** 0.009***
(0.002) (0.002) (0.002) (0.002) (0.003) (0.003)
Non-interest income 0.151*** 0.190** 0.125* 0.175* 0.138* 0.238***
(0.058) (0.078) (0.069) (0.093) (0.073) (0.09)
Opportunity cost 0.033*** 0.032*** 0.025*** 0.026*** 0.044*** 0.048***
(0.008) (0.008) (0.009) (0.009) (0.009) (0.009)
Market volatility 0.022*** 0.022*** 0.019** 0.019** 0.029* 0.026*
(0.007) (0.007) (0.008) (0.008) (0.015) (0.015)

Firm fixed effect Yes Yes Yes Yes Yes Yes

Year fixed effect Yes Yes Yes Yes Yes Yes
Observations 2239 2185 1746 1714 493 471
R2 0.128 0.125 0.123 0.132 0.349 0.376

2. The model

In this section, we present a model for an Islamic bank to understand the impact of different determinants on their profitability. We
are particularly interested in the impact of the loan to deposit ratio, fee-based asset side transactions, market power, efficiency, risk and
religiosity on Islamic bank's profitability. In terms of the basic setup, our model is closest to Ueda (2004) and Azmat et al. (2015). We
build a two-period model, where the Islamic bank interacts with the depositors and their asset side customers.
In the first period, the bank takes funds from the depositors and allocates these funds amongst the customers on the asset side. The
bank has the choice of either lending,7 through sale or lease-based products or disbursing the funds using a fee-based arrangement. In
the second period, the outcome of the bank's lending decisions become apparent. The asset side customers return the principal and the
profit if their projects succeed, while in case the default Islamic bank is only able to recover part of the principal amount. We assume that
both the depositors and the borrowers experience some religious utility from interacting with an Islamic bank, though it can be different
for different customers. We follow Acharya and Naqvi (2012) to model the way the customer's reservation utility may affect the required
rate of return. We also assume that the fee-based transactions may be less risky than lending, as the bank's returns are less exposed to the
outcomes in the different state of the world. The literature on costly state verification can be used to justify this assumption (see
Chaudry, Azmat, & Sohail, 2018). The model also incorporates the fact that the lending operation may be subject to religious limitations
as the approval of financial products has to pass through a Shariah screening process. This, in a way, can impose a cost on the Islamic
bank or also may limit the lending portfolio space.

7
Technically Islamic banks do not lend but make trade based transactions with their asset side customers but for convenience we would be using
the terms lending and borrowing.

7
A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 6
NIM, market power, loan to deposit ratio and the bank fee during 2000–2009. This table presents regression results of equation (13) for the
period when Islamic banks’ market power was higher than the conventional banks. *, ** and *** indicate the significance of t-tests at 10%, 5%
and 1%, respectively. In parentheses are the standard errors, which are robust to heteroscedasticity and serial (cross-sectional) correlation.
Variables of interest Dependent variable: Net interest margin

Full-sample Conventional-bank Islamic-bank

Loan-to-deposit ratio 0.0001 0.0003 0.00001

(0.0001) (0.0003) (0.00003)
Fee 1.421** 1.355* 1.081***
(0.587) (0.761) (0.372)

Controls

Lerner 0.132** 0.147** 0.063***

(0.056) (0.064) (0.016)
Deposit-to-asset ratio 0.045 0.066 0.002
(0.041) (0.059) (0.023)
Efficiency 0.00004 0.0001 0.0001*
(0.00005) (0.00004) (0.0001)
Operating cost 0.782 0.774 0.322
(0.704) (0.734) (0.679)
Credit risk 0.0004 0.0005 0.0001
(0.0004) (0.0005) (0.001)
Risk aversion 0.00002 0.001 0.001*
(0.001) (0.002) (0.0004)
Log(Total assets) 0.003 0.004 0.011
(0.007) (0.007) (0.009)
Non-interest income 0.979** 0.997* 1.049***
(0.424) (0.514) (0.343)
Opportunity cost 0.045 0.059 0.007
(0.046) (0.050) (0.030)
Market volatility 0.005 0.004 0.004
(0.028) (0.034) (0.022)

Firm fixed effect Yes Yes Yes

Year fixed effect Yes Yes Yes
Observations 836 674 162
R2 0.12 0.135 0.222

2.1. Depositor's utility function

We start with the depositors who maximise their utility as shown by Equation (1) below. Here ‘P’ is the probability of an Islamic
bank's success; it can also be considered as the macroeconomic risk in the system, which affects all participants. 'RD ' is the rate of return
offered to the depositor. ‘D’ is the total deposits. ‘λ’ is the recovery rate representing the proportion of the principal the depositor would
receive in case of a bankruptcy. 'D' is the religious utility which the depositor experiences from the transaction knowing that it is
compliant with Islamic law. 'U' is the depositor's reservation utility, the minimum utility that the borrower would like in a competitive
market for it to participate. ‘m ’ represents the Islamic bank's market power relative to the depositor. If ‘m’ is negative, Islamic banks
have greater market power than the depositors, while it is positive if depositors hold greater market power.

UðDÞ ¼ PðDð1 þ RD Þ  DÞ þ ð1  PÞððλD  DÞ þ D  U þ m (1)

Assuming binding constraints in Equation (1), it can be shown that the optimal rate of return for the depositor is as follows:

U þ m þ Dð1  λÞð1  PÞ  D
RD ¼ (2)
PD

Proposition 1. The optimal rate of return for depositors, as indicated by Equation (1), shows that the deposit rate is an outcome of the
customer’s reservation utility, the Islamic bank’s market power, the recovery rate upon default, the overall risk of the bank, the size of the deposit
and the customer’s religiosity.

2.2. The borrower's profit function

In our model of an Islamic bank, we assume that there are good and bad borrowers. The bank observes the signals and only knows the
probability of a borrower being good or bad. The profit function of a good borrower is shown by Equation (3) while that of the bad
borrower is shown by Equation (4).

π G ðLÞ ¼ PðϕG L  ð1 þ RG ÞLÞ þ ð1  PÞððL  λL LÞ þ L  B þ mL (3)

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A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 7
NIM, loan to deposit ratio and the bank fee during 2002–2013. This table presents regression results of equation (13) for the period when
Islamic banks’ loan to deposit ratio was higher than the conventional banks. *, ** and *** indicate the significance of t-tests at 10%, 5% and 1%,
respectively. In parentheses are the standard errors, which are robust to heteroscedasticity and serial (cross-sectional) correlation.
Variables of interest Dependent variable: Net interest margin

Full-sample Conventional-bank Islamic-bank

Loan-to-deposit ratio 0.0001* 0.001*** 0.00002

(0.0001) (0.0002) (0.00002)
Fee 0.526* 0.585 0.664***
(0.312) (0.610) (0.257)

Controls

Lerner 0.129*** 0.136** 0.077***

(0.039) (0.053) (0.015)
Deposit-to-asset ratio 0.032 0.084** 0.009
(0.028) (0.042) (0.012)
Efficiency 0.00001 0.000 0.0001**
(0.0001) (0.00004) (0.0001)
Operating cost 0.215 0.236 0.498
(0.276) (0.312) (0.398)
Credit risk 0.001* 0.0005 0.0003
(0.0003) (0.0004) (0.0003)
Risk aversion 0.001*** 0.002*** 0.001**
(0.0004) (0.001) (0.0004)
Log(Total assets) 0.001 0.002 0.014
(0.007) (0.008) (0.009)
Non-interest income 0.360* 0.272 0.757***
(0.192) (0.214) 0.237
Opportunity cost 0.007 0.020 0.011
(0.042) (0.053) (0.020)
Market volatility 0.004 0.002 0.007
(0.025) (0.031) (0.019)

Firm fixed effect Yes Yes Yes

Year fixed effect Yes Yes Yes
Observations 1682 1330 352
R2 0.075 0.092 0.277

π B ðLÞ ¼ PðϕB L  ð1 þ RB ÞLÞ þ ð1  PÞððL  λL LÞ þ L  B þ mL (4)

where ϕG is the potential profit rate for a good borrower and ϕB is the profit rate for a bad borrower. By construction ϕG > ϕB . RG is the
rate of return on the loan repaid to the bank by good borrowers. RB is the rate of return on loans paid by bad borrowers. L is the size of the
loan. P is the probability of success. λL is the revovery rate in case of default. L is the religious utility experienced by the borrower. B is the
borrower's reservation profit and mL is the relative market power of the bank with regards to the borrower.
By assuming binding constraints, Equations (3) and (4) can be reduced to Equations (5) and (6) respectively.

ðL  B  mL Þ  λL Lð1  PÞ þ Lð1  PÞ  LP þ PϕG L

RG ¼ (5)
PL

ðL  B  mL Þ  λL Lð1  PÞ þ Lð1  PÞ  LP þ PϕB L

RB ¼ (6)
PL

Proposition 2. The optimal rate of return on loans paid by a good and bad borrower is given by Equations (5) and (6). The rate of return is
determined by the religiosity of the borrower, the reservation profit for participation, the relative market power, the recovery rate upon default, the
profitability of the project upon success, the overall risk of the venture and the size of borrowing.

2.3. Islamic bank's profitability function

Given the good and bad borrowers, Islamic banks profitability would be dependent on their ability to neutralise information
asymmetry and lend to good borrowers. We assume in the model the proportion of good borrower is α and proportion of bad borrowers
is (1-α). The Islamic bank's profitability function is represented by Equation (7).

π ¼ αðPðRG LG  RD DÞ þ ð1  PÞðλL L  λD D þ RRÞÞ þ ð1  αÞðPðRB LB  RD DÞ þ ð1  PÞðλL L  λD D þ RRÞÞ þ RF F  xðλF FÞ (7)

Where

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A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 8
NIM, piety premium, loan to deposit ratio and the bank fee during 2006–2013. This table presents regression results of equation (13) for the
period when Islamic banks enjoyed a piety premium. *, ** and *** indicate the significance of t-tests at 10%, 5% and 1%, respectively. In
parentheses are the standard errors, which are robust to heteroscedasticity and serial (cross-sectional) correlation.
Variables of interest Dependent variable: Net interest margin

Full-sample Conventional-bank Islamic-bank

Loan-to-deposit ratio 0.0001* 0.001*** 0.00003**
(0.00005) (0.0002) (0.00002)
Fee 0.422 0.237 0.559*
(0.279) (0.468) (0.306)

Controls

Lerner 0.152*** 0.163*** 0.087***

(0.045) (0.061) (0.014)
Deposit-to-asset ratio 0.031 0.098** 0.019
(0.03) (0.044) (0.012)
Efficiency 0.00001 0.00001 0.0001*
(0.00004) (0.00004) (0.00005)
Operating cost 0.291 0.271 0.357
(0.276) (0.279) (0.357)
Credit risk 0.001*** 0.0004 0.0003
(0.0002) (0.0003) (0.0003)
Risk aversion 0.002*** 0.002*** 0.001**
(0.0004) (0.0005) (0.0004)
Log(Total assets) 0.002 0.003 0.013*
(0.007) (0.009) (0.008)
Non-interest income 0.427** 0.400* 0.611**
(0.213) (0.225) (0.273)
Opportunity cost 0.019 0.016 0.023
(0.057) (0.07) (0.018)
Market volatility 0.019 0.007 0.054*
(0.031) (0.034) (0.031)

Firm fixed effect Yes Yes Yes

Year fixed effect Yes Yes Yes
Observations 1734 1357 377
R2 0.097 0.114 0.319

D ¼ L þ RR þ F (8)
In addition to the variables used in the previous equations, here RR is the amount kept in reserves by the bank. F is the amount of
funds allocated to fee based transactions. RF is the return on fee, x is the probability of failure and λF is the recovery rate.
Equation (7) can be reduced to Equation (9):

π ¼ ðPðαRG LG þ ð1  αÞRB LB  RD DÞÞ þ ð1  PÞðλL L  λD D þ RRÞÞ þ RF F  xðλF FÞ (9)

Substituting the optimal deposit and the borrowing rates from Equation (2) and Equations (5) and (6) we get Equation (10):

π ¼ PL (10)

To identify the impact of the loan to deposit ratio on Islamic bank's profitability, we use a simple mathematical manipulation. We
divide Equation (10) with D to identify profit for each unit of deposit. This results in Equation (11).

π L
¼P (11)
D D
Taking the first derivative of profit per unit deposit with respect to the loan to deposit ratio generates Equation (12).

∂Dπ
¼ PðαðϕG Þ þ ð1  αÞðϕB ÞÞ þ ð1  PÞ  P  λð1  PÞ  RF þ xλF (12)
∂DL
We can observe that Equation (12) yields a positive return (greater than zero) with the condition shown in Equation (13).

RF  xλF þ λ  1
P> (13)
ðαðϕG Þ þ ð1  αÞðϕB ÞÞ  2 þ λ
The above findings help us to formulate Propositions 3 to 5.
Proposition 3. The profit per deposit for the Islamic bank would increase with a loan to deposit ratio if the probability of success is determined
RF xλF þλ1
by Equation (12) where P > ðαðϕ Þþð1 αÞðϕ ÞÞ2þλ .
G B

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A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Proposition 4. Equations (12) and (13) suggest that an increase in the Islamic banks' ability to make good loans could result in a higher loan
to deposit ratio, which enhances the Islamic bank's profitability. However, if the religious constraints limit the Islamic bank's ability to cater to a
good borrower or reduce the choice of their lending portfolio, then an increase in loan to deposit ratio may cause a decrease in Islamic bank's
profitability.
Proposition 5. Equations (12) and (13) also suggests that an increase in the reliance on fee-based transactions as a proportion of Islamic
bank's profitability can cause the impact of the loan to deposit ratio to become unresponsive on bank's profitability. While Equation (13) shows
that the Islamic bank's probability for positive profit increases with the increase in return for a fee.
In the next section, we provide empirical support to our theoretical prepositions.

3. Data and methodology

We use a dataset covering a large sample of countries where both Islamic and conventional banks co-exist. The analysis includes
countries with data on at least four banks for a minimum of two-year observations. We remove outliers in all variables by winsorizing
them at the 1st and 99th percentiles within each country. This eventually leaves us with the data that covers the period from 2000 to
2015 for 20 Muslim-majority countries. We allow banks to enter and exit during the sample period. After excluding banks that have
incomplete data, the final sample includes annual information for an unbalanced panel of 2599 observations: 1991 are for conventional
banks, and 608 are for Islamic banks. Bank-level data for all countries in the sample are from the Orbis and Bankscope databases while
missing data are collected from banks’ annual reports. Macroeconomic data are collected from Thomson Reuters DataStream.

3.1. Empirical model and the method of estimation

Most of the existing studies use net interest margin (NIM) as a proxy of a bank's profitability. The NIM is calculated as the difference
between interest income and interest expense as a proportion of total earning asset. Interest expense margin (IEM) is also used as an
alternative measure of bank performance (see, for instance, Entrop, Memmel, Ruprecht, & Wilkens, 2015). The IEM captures interest
expense to total interest-paying liabilities, which consist of interbank and non-bank funding, deposit accounts and securities issued. It is
worth noting that, for Islamic banks, a large proportion of interest income comes from Murabaha (lending) accounts while the bulk of
interest expenses goes to Mudarabah (deposit) accounts.
Along with competition (Ho & Saunders, 1981), several determinants of interest margin have surfaced in the literature, such as
operating cost, credit risk, market risk, efficiency, liquidity, opportunity cost, volatility, etc. (e.g., Hawtrey & Liang, 2008; Kasman,
Tunc, Vardar, & Okan, 2010; Maudos & De Guevara, 2004).
To corroborate the theoretical arguments and proofs in Section 2, we identify loan to deposit ratio and fee income8 as the key
variables of interest along with the other bank-specific and macroeconomic control variables that are used in the existing literature.
Following Maudos and Solís (2009) and Kasman et al. (2010), we use a single-stage regression technique based on a behavioural model
of the bank in which various potential determinants of interest margin are included. Thus, our model to test the impact of the loan to
deposit ratio and fee on interest margin is as follows:

yit ¼ β' xit þ γ ' zit þ fi þ tt þ eit (14)

where yit is for the bank's profitability measures namely NIM and IEM, xit is the vector of the variables of interest, which includes loan to
deposit ratio and the bank fee, vector zit controls for other banks and country specific factors. We control for firm-fixed effects (fi ) and
year-fixed effects ðtt Þ in order to control for the structural changes in banking and general economic conditions, such as differences in
legislation, accounting standards, and tax structures, which may vary across banks and over time. The significance of the parameter β
determines the role of loan to deposit ratio and the bank fee for the bank's profitability. We provide details of the variables included in
the vector z below.

3.2. Control variables

We control for market power, operating costs, credit risk, risk aversion, bank size, net non-interest income, opportunity cost, the
quality of management (efficiency) and the market volatility. Below we discuss how we measure them and how they relate to the
dependent variable.
Since Islamic banks have become significant banking service providers, we expect that they have to face both internal (among Is-
lamic banks) and external competition (with the conventional bank). Among the various indicators of competition, the Lerner index is
extensively used in the literature as it can be computed at the individual bank level. This index is defined as the difference between the
price and marginal cost, divided by the price. It measures the ability to determine prices above the marginal cost, being an inverse
function of the elasticity of demand and the number of banks. The value of the index ranges from 0 (perfect competition) to 1 (mo-
nopoly). We follow the procedure proposed by Kumbhakar, Baardsen, and Lien (2012) and Coccorese (2014) to compute the Lerner
index, which has an advantage over other conventional methods.

8
We have used both fee to total operating income and fee to total assets.

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A.S.M.S. Azad et al. International Review of Economics and Finance xxx (xxxx) xxx

Operating costs are measured by the ratio of operating expenses to total assets. To cover higher operating costs, banks may charge/
demand a higher interest rate. Hence, consistent with the existing studies, we expect a positive relationship between operating cost and
the bank's interest margin (Kasman et al., 2010; Maudos & De Guevara, 2004; Maudos & Solís, 2009). We proxy the credit risk by the
quotient of loan impairment to the net loan. A bank charges a higher interest rate if the credit risk is higher for a customer. Consistent
with the existing studies, we also expect a positive relationship between credit risk and interest rate (Maudos & Solís, 2009; McShane &
Sharpe, 1985; Valverde & Fernandez, 2007).
We compute risk aversion by the ratio of equity to total assets. As per the theory, we expect a risk-averse bank will charge higher
interest to cover the risk of equity financing compared to debt (e.g., Entrop et al., 2015; Maudos & Solís, 2009; Valverde & Fernandez,
2007). The logarithm of total assets measures the bank size. There is mixed evidence about the relationship between bank size and the
interest rate (Hawtrey & Liang, 2008; Kasman et al., 2010). We use net non-interest income, measured as the ratio of net non-interest
income (non-interest income minus non-interest expense) to total assets, to capture the diversification strategy of banks. If banks
generate income from non-interest activities, it enables banks to offer a lower interest rate on lending activities. Hence, following Lepetit
et al. (2008) and Maudos and Solís (2009), we expect a negative relationship between non-interest income and net interest margin.
We use the opportunity cost of holding reserves, estimated by the ratio of liquid reserves (cash and cash equivalent variables) to total
assets to measure a bank's conservative investment strategy. Since the conservative strategy yields low return due to higher liquidity/
reserves, banks pursue to make up this opportunity cost by charging a higher interest rate on lending. Hence, following Maudos and Solís
(2009) and Entrop et al. (2015), we expect a positive relationship between opportunity cost and the bank profit margin. The quality of
management (efficiency) is proxied by the cost-to-gross income ratio. High levels of operating cost per unit of gross income reflect banks'
inefficiency. High-cost liabilities and/or less profitable investments signal the inefficiency of management, which results in a negative
relationship between the quality of management and bank's profitability (Angbazo, 1997; Kasman et al., 2010).
Of the various macroeconomic control variables, the existing literature uses GDP growth rate and the inflation rate. Results relating
to the relationship of GDP growth rate and the inflation rate with the net interest margin are mixed (Maudos & Solís, 2009). Since
market-based measures are forward-looking, we use the stock market volatility to reflect the changes, uncertainties and variations
accompanied by macroeconomic variables. Following Rangel and Engle’s (2012) asymmetric Spline GARCH approach, we obtain the
long-term component of market volatility that is free from noise and contains valuable information embedded in the key macroeconomic
variables.

4. Empirical results and discussion

4.1. Summary statistics and correlation matrix

Table 1 presents the summary statistics of Islamic and conventional banks. The average net interest margin (NIM) of Islamic banks is
much higher than that of conventional banks; the average interest expense margin (IEM) is same for both Islamic and conventional
banks. A higher NIM of Islamic bank for a given level of IEM implies that Islamic bank charges a piety premium.
Among the explanatory variables of our interest, the average loan-to-deposit ratio is higher for Islamic banks (104.64) than for
conventional banks (85.99), similar evidence is reported by Beck, Demigruc-Kunt and Merrouche (2013) and Olson and Zoubi (2017).
This suggests that Islamic banks show higher intermediation efficiency than conventional banks. The average fee income is same for the
Islamic and conventional banks, but the maximum value of fee income is higher for Islamic banks (12%) than for conventional banks
(5%) indicating asymmetric fee distribution. This implies that an Islamic bank may charge its customer a higher fee as compared to their
conventional counterparts. The competitive market structure, proxied by the Lerner index, is higher for Islamic banks (0.21) than for
conventional banks (0.15), exhibiting Islamic banks having more market power than conventional banks. Alternatively speaking,
conventional banks are relatively more competitive than Islamic banks. Credit risk in Islamic banks is lower than conventional banks.
The risk aversion ratio is higher for Islamic banks than conventional banks, indicating that Islamic banks have a lower risk profile
than conventional banks. Both net non-interest income and net fee income are very similar for both types of banks. Islamic banks have
higher opportunity costs (10.30%) than conventional banks (8.9%), indicating the conservative investment approach of Islamic banks.
Management efficiency, measured as the ratio of cost-to-gross revenue, is lower in Islamic banks (i.e., higher cost-to-gross revenue) than
conventional banks. This could be due to their shorter operating history, conservative investments and higher operating costs. So, a large
portion of piety premium could be consumed by the managerial inefficiency of Islamic banks.
Looking at the correlation matrix for Islamic banks (Table 2), we observe that both the loan to deposit ratio and fee income are
positively associated with net interest margin (NIM) and interest expense margin (IEM). However, the size of the coefficient is higher for
IEM (0.184) than for NIM (0.151). NIM is also positively correlated with operating costs and risk aversion and negatively correlated with
credit risk, non-interest income and the opportunity cost. Market power and other control variables namely bank size (log of total
assets), non-interest income and opportunity cost are all negatively correlated with IEM, while managerial inefficiency, operating cost,
credit risk and market volatility are positively correlated with IEM.
Almost similar results are observed for conventional banks (Table 3). We find that both the loan to deposit ratio and fee income are
positively associated with both NIM and IEM. However, unlike Islamic banks, the size of the coefficient of correlation is higher for NIM
(0.314) than IEM (0.001). This implies that the loan to deposit ratio contributes more to the profitability of the conventional banks than
that of Islamic banks. Similar to Islamic banks, NIM is positively correlated with operating costs, risk aversion and the deposit to asset
ratio, while it is negatively correlated with credit risk, non-interest income and opportunity cost. Market power and other control
variables namely risk aversion, bank size (log of total assets), non-interest income and opportunity cost are negatively correlated with
IEM, while managerial inefficiency, operating cost, credit risk and market volatility are positively correlated with the IEM.

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4.2. Regression results

Our main estimation results are presented in Tables 4 and 5. Table 4 reports results related to NIM, while Table 5 presents the results
related to IEM. In both tables, M1 shows the empirical results based on the influence of loan to deposit ratio only, while M2 presents the
results with both loan to deposit ratio and fee-based income on the profitability of the bank. Below we compare and discuss the results of
both types of banks.
In Table 4, we find that the coefficient of the loan to deposit ratio is positive and statistically significant for conventional banks, but
statistically insignificant (and negative) for Islamic banks. This suggests that conventional banks are successful in their core businesses
despite having lower intermediation efficiency (i.e., converting deposits into lending) than Islamic banks (see Table 1 for LDR com-
parison). However, this success comes with their higher credit risk-taking as compared to Islamic banks because credit risk is negative
and statistically significant for conventional banks (Abedifar et al., 2013).
On the contrary, Islamic banks fail to achieve any significant outcome from profit raising opportunities despite having higher market
power than conventional banks for most of our sample period (see also Fig. 1). That is, given the higher market power and interme-
diation efficiency, Islamic banks are unable to translate deposit into profitable lending. An explanation for this finding is that Islamic
banks are much more involved in the process of asset creation and equity generation than mere lending (Wanke, Azad, Emrouznejad, &
Antunes, 2019).
When we add the variable fee income in model M2, we find that the loan to deposit ratio remains statistically significant for con-
ventional banks and insignificant for Islamic banks. Interestingly, fee income turns out to be insignificant for conventional banks but
significant for Islamic banks. This may suggest Islamic banks' reliance on fee-based income to raise their profit performance. This finding
is also consistent with those of Demirgüç-Kunt and Huizinga (1999), Stiroh (2004) and Lepetit et al. (2008), who provide empirical
support of conventional banks' reliance on fee-based income in Eastern Europe and the US in the 1980s and 90s. Both the sign and
statistical significance for other variables remain the same except operating cost, which turns out to be insignificant. Of the other
variables, market power and risk aversion enhance Islamic banks’ profitability, while managerial inefficiency and non-interest income
negatively affect the profitability of Islamic banks. The statistical insignificance of the loan to deposit ratio accompanied by the risk
aversion points to the lower risk-taking by Islamic banks. Their reduced risk-taking is attributed to managerial inefficiency and the
risk-sharing nature of customer deposits (see, for instance, Beck, Demigruc-Kunt & Merrouche, 2013 and Abedifar et al., 2013).
Results on another performance measure, interest expense margin (IEM), are presented in Table 5. A negative relation between loan
to deposit ratio and interest expense margin (IEM) for conventional bank suggests that conventional bank has an incentive to expand
their investment from the perspective of marginal cost reduction. As the higher lending reduces the IEM and as the manager's
compensation is linked to higher lending, conventional banks desperately seek to extend their lending. Since the lending results in lower
interest expense (IEM) and higher interest margin (NIM), this may lead to an asset price bubble and burst (Acharya & Naqvi, 2012). A
positive relationship between LDR and IEM for Islamic banks suggest that there is no incremental benefit of increasing lending to reduce
the interest expense margin. We provide two reasons for such a finding. First, Islamic banking is based on profit and loss/risk-sharing,
equity participation and asset creation, which leads them to take a conservative investment strategy (see also, Wanke et al., 2019).
Second, Islamic banks are less efficient than conventional banks because of the piety premium as well as their inexperience, managerial
inefficiency and lower scale benefit (Azad et al., 2018; Beck, Demigruc-Kunt & Merrouche, 2013). Thus, for an Islamic bank, higher
lending does not necessarily reduce costing (IEM) rather increases it. These results remain the same when we include fee income in our
estimation in M2. Finally, fee income neither increases nor decreases the interest expense (IEM) of either type of banks.

4.3. Robustness check

We now check whether our main regression results are robust, particularly throughout different sub-sample analysis surrounding
puzzling issues of piety premium, market power and performance. For example, given the higher market power and Shariah compliance,
one can presume that Islamic banks could charge a higher premium, which can persuade them to involve in more lending activities.
Therefore, we first present the sub-sample analysis relating to the period in which Islamic banks enjoyed higher market power than
conventional banks. As indicated in Fig. 1, Islamic banks had enjoyed higher market power from 2000 to 2009 for a decade. Not a mere
coincidence but during the same period (even extending to 2013), Islamic banks had a higher loan to deposit ratio compared to con-
ventional banks (Fig. 2). Presumably, one can expect that the higher market power along with the higher loan-to-deposit ratio should
strengthen the relationship between LDR and NIM. However, Table 6 shows that between fee income and loan to deposit ratio, the LDR
is not significant but fee income is the most dominant driver of net income margin for both the Islamic and conventional banks.
Interestingly, the statistical significance of the fee income is higher for Islamic banks.
Table 7 presents our second set of robust results for the period between 2000 and 2013 when Islamic banks’ loan to deposit ratio was
higher than conventional banks. The results show that fee remains to be highly significant, and the loan to deposit ratio remains to be
statistically insignificant for the Islamic banks. For conventional banks, loan to deposit ratio is the main driver of the net income margin.
Finally, in Table 8, we present the sub-sample analysis relating to higher piety premium period. As Fig. 3 suggests, a positive piety
premium can be observed for the period from 2006 to 2013. The results remain to be consistent for conventional banks. For Islamic
banks, we find slightly different yet interesting results. During the positive piety premium regime, the fee income remains to be positive
and statistically significant, and the loan to deposit ratio now becomes statistically significant. The negative sign in times of positive
piety premium period suggests that higher lending would deteriorate their profitability performance and hence act as a self-disciplinary
role. This would deter them from lending and make them more cautious in risk-taking. Robust results are also obtained for interest
expense margin (IEM) as well as for crisis (GFC) and normal periods but not reported to conserve the space.

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Overall, our findings related to Islamic banks are consistent with the banking literature that finds the significance of non-interest
income for conventional banks at their earlier stages of development (see for instance, Demirgüç-Kunt & Huizinga, 1999; Stiroh,
2004; Lepetit et al., 2008; Maudos & Solís, 2009 and Cantrell & Yust, 2018). Demirgüç-Kunt and Huizinga (1999) show that banks in
Eastern Europe relied heavily on fee-based operations during the late 1980s to mid-90s. Moreover, Lepetit et al. (2008) report that the
US commercial banks’ share of fee-based income to total income in the 1980s was 19%, which later increased to 43% (Stiroh, 2004).
Concerning fee, the findings are also in line with those of Cantrell and Yust (2018), who find that banks in highly religious countries
appear to offset the loss of expected gains from lending with additional fee income. (Islamic) banks can ensure this performance due to
stronger customer relationships resulting from the community-based lending.
The implications of our findings are that regulations in the traditional sense can impose a cost on the participants in the financial
markets, but it also promises a long-term benefit. For instance, the adherence to religious laws may reduce the financing opportunities
for Islamic banks, making the process of intermediation a bit more challenging. However, these apparent limitations to the pursuit of
return maximisation and risk minimisation may lead the Islamic banks to alternative ways to serve their customer, which may be
profitable, and be compliant with their religious requirements.

5. Conclusion

In this paper, we study how the process of intermediation can be different in Islamic and conventional banks. Specifically, we show
how lending and non-lending (fee-based income) activities of banks play different roles in conventional and Islamic banks. By so doing,
we contribute to the literature on the determinants of the Islamic bank's profitability by offering theoretical and empirical insights into
how loan to deposit ratio and fee income may affect the profitability of Islamic and conventional banks differently.
We build a theoretical model where the bank takes deposits from customers with a varying degree of religiosity and converts these
deposits into lending or fee-based income arrangement. Incorporating issues of asymmetric information, risk, market power and reli-
giosity in the model, we examine how lending can have minimal effect on Islamic bank's profitability. We find that in an environment
fraught with information asymmetry and risk, an increase in lending may not be beneficial for Islamic banks. We also find that the
challenges of Islamic bank lending can cause non-lending modes such as a fee-based transaction to be profitable ways to deal with excess
liquidity.
We provide empirical support to the theoretical findings that the Islamic banks, as compared to conventional banks, have a greater
reliance on fee than returns from loans to increase their profitability. This suggests that measures such as loan to deposit ratio may affect
the Islamic bank's profitability less significantly than conventional banks. We argue that this may be due to the size of Islamic banks (i.e.,
economies of scale), their business experience and religious requirements. The significant impact of fee-based income over loan income
raises the concern of Islamic bank's sustainability in the future. The future research may explore whether lower credit risk taking coupled
with higher market power and over-reliance of fee-based income enhances or limits the growth, profitability and sustainability of banks.

Acknowledgement

We thank the Editor, Guest Editor and two anonymous referees for valuable comments and suggestions, which greatly improved the
quality of our paper. All remaining errors and misinterpretations are ours.

Appendix A. Supplementary data

Supplementary data to this article can be found online at https://doi.org/10.1016/j.iref.2019.05.015.

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