List of Tables

Table 3.1 Descriptive Statistics Table 4.1 Islamic and Conventional Bank Ratios Table 4.2 Correlation Matrix Table 4.3 Regression Results of the Complete Sample Table 4.4 Conventional Banking Regression Results Table 4.5 Regression Results of Islamic Banking 28 33 38 41 43 45

List of Figures
Figure 3.1 ROA of Conventional and Islamic Banks Figure 3.2 ROE of Conventional and Islamic Banks 30 30

List of Appendices
Appendix 1 Real GDP (Millions USD) Appendix 2 GDP Growth (%) Appendix 3 GDP Per Capita (USD) Appendix 4 Exports in the GCC (Millions USD) Appendix 5 Imports in the GCC (Millions USD) 60 61 62 63 64

Executive Summary

Executive Summary

The aim of this dissertation was to examine the profitability of the Islamic and conventional banking in the Gulf Cooperation Council (GCC). Islamic banks generally operate on the basis of the Sharia law. This law prohibits riba, commonly known as interest. Hence the Islamic banks operate on an interestfree lending basis. Dr. Ahmed Alnajar, the founder of the idea of Islamic banks started his own small Islamic bank in Egypt with the help of ideas from banks in Germany. A number of articles have been summarized and reviewed in order to understand the profitability of the banks. Short (1979), Bourke (1989) and Molyneux and Thornton (1992) were some of the authors who have studied the profitability of banks in various regions. They found positive and negative relations of variables on the profitability of banks. Later previously written literature on the profitability of Islamic banks have been discussed. ROA and ROE were the profitability indicators that were used by authors to study the profitability of Islamic banks. It is concluded that the profitability of Islamic banks is comparable to those of Conventional banks. A total of 34 banks in the GCC have been selected as a sample to review their profitability. Out of the 34 banks 16 are Islamic banks and the remaining 18 are conventional banks. A comparative study of the ratios is done for both the kinds of banking. This is then followed by the regression analysis based on 3 dependent variables namely ROA, ROE and NIM and 6 independent variables namely Total Assets (TA), Total Equity to Total Assets (TE/TA), Total Loans to Total Assets (TL/TA), Deposits to Total Assets, Total Expenses to Total Assets and Non-Interest Expense to Total Expense. The results of the regression analysis shows that key internal bank characteristics show positive and negative as well as significant and insignificant
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relations with the profitability indicators. The results of the regression obtained for the conventional banks were compared to the results obtained in the study done by Ben Naceur (2003). However the results of regression obtained for the Islamic banks were compared to those obtained in the study done by Bashir and Hassan (2004). Finally, it has been concluded that the results obtained for the profitability of Islamic banking in the GCC were consistent with the studies done previously. There are also a few limitations for this study which is mentioned.

Chapter 1 Background and Objectives

Background and Objectives

The strong demand from the Islamic world for a banking system that works without the factor of interest brought about the evolution of Islamic Banks. According to Iqbal and Molyneux (2005), Islamic banking was established for the first time in an Egyptian small town by Dr. Ahmed Alnajar in 1963. Dr. Ahmed Alnajar had completed his studies in Germany and noticed that there were many savings banks that operated on the interest factor. With the idea adopted from a savings bank n Germany, he started a small Islamic bank of his own that operated interest-free. He was the pioneer of this leading idea in the banking world. Once the establishment of this small bank proved successful, many other Islamic banks were established. The founding of the Nasser Social Bank in Egypt followed in 1971. By 1975 the idea of Islamic banking had spread to other Islamic regions. This triggered the establishment of Dubai Islamic Bank in United Arab Emirates and the Islamic Development Bank (IDB) in Jeddah, Saudi Arabia (Wilson; 1990). As per the report by The International Association of Islamic Banks (IAIB) in 2004, there were 267 Islamic banks spread across 48 countries with a total asset size of $260 billion. Though Islamic banks have been there for only 30 years and is still on a stage of evolution, it strives in maintaining its position in the banking industry. Many countries such as Pakistan, UAE, Iran, Sudan etc use Islamic banking and follow the rules as per the Sharia law for all banking activities. The operation of Islamic banks is spreading throughout the world and thus is not limited only to the Islamic countries. The reason being that "Growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity could have a significant impact on the pattern of world trade" (Abdel-Magid; 1981).
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Islamic banks follow the rules of the Islamic Sharia law which have been derived from the Quran and Prophet Mohammeds sayings. The three key practices that have been prohibited by the Sharia law are Riba (Interest), Gharar (Uncertainty) and Maysir (Betting). Islamic Banking, also known as profit and loss sharing or interest -free banking (Hassan and Zaher; 2001) is about thirty years old. As it has been there for quite some time, it has become a part of the banking industry. It has become one of the fastest growing segments of the banking industry. Islamic banking is present in major Islamic countries. However due to the nature of its business and the rules and principles on which it works, Islamic banking is now existent in many non-Islamic countries as well. Islamic banking is a different way of banking wherein the customers are given the same services free of any interest. As per the Islamic principles and teachings (known as Sharia in Arabic) giving and taking of interest (the Arabic term for which is riba) is prohibited and hence Muslims are compelled to do business without the involvement of any interest or usury. This prohibition makes Islamic banking stand out in comparison with the conventional banking systems. In contrast to this, conventional banks operate on the basis of interest. The difference between the interest that the banks pay to investors and the interest that the banks charge the borrowers is the income for conventional banks. This common banking method is followed around the world. However Islamic banking does not follow this system as it involves the element of interest. Islamic banking had been experimented from a long time however the first Islamic bank ever to come into existence was the Faisal Islamic Bank established in Sudan in the year 1977. The conventional banks started opening their Islamic banking cells and it has been growing enormously since then. Though there have been a lot of Islamic banks that were opened all over the world, it was only introduced to Muslims at first. This was done so that the Muslims could do their banking as per the Holy book Quran. However, this facility has been extended to
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non-Muslims as well. As per the forum conducted by KPMG, Islamic banks may account for 40 to 50 % of the Muslims total savings within the next decade. All over the world there are 270 or more banks that operate as per the Islamic Sharia. It is further estimated that their assets are around $265 billion and they are having a growth rate of approx 15%. Though Islamic banking is offered to all the people, Muslims and Non-Muslims, there is not much awareness of the benefits behind Islamic banking. People are under the impression that this kind of banks are generally for Muslims only, due to the name Islamic Banking. Also after the 9/11 attack on the US twin towers; the word Islam brings back memories of terror. As a result they avoid such banking. In Islamic banks the customers having an account, generally share the profits and losses of the banks. They are not paid any interest on their balance as done by conventional banks. In lieu of the interest, the customers get the share of profits. However if the bank makes a loss in its investment the customers share the loss as well. This makes it very important for an Islamic banking customer to know how is bank is doing in its business. And weather the interest in conventional banks is better or the profits in Islamic banks. In the real world, people have become more money minded and so focus on the ideas and proposals where they are able to make money. As of today, Islamic banking is growing phenomenally throughout the world. However there has been no research conducted to identify which is more beneficial to common man. This dissertation studies the profitability of Islamic banks in the Gulf Cooperation Council (GCC). The profitability and working of the Islamic banks have been compared to that of Conventional banking. This would give an insight into the profitability of both the banking systems.

Aims of Study
This dissertation aims at presenting an empirical investigation into the Islamic and conventional banking in the GCC. The study of the profitability of the banks will look at various banking characteristics such as capitalization, liquidity and size. The main objectives of the study are as follows To critically analyze the working of Islamic Banks. To critically evaluate the profitability of Islamic banks as compared to Conventional Banks. To collate the above mentioned objectives so as to give a clear view on the profitability of Islamic banking in the GCC. In order to achieve the above mentioned objectives a number of questions have also been established. What is Islamic banking? How do Islamic banking work in comparison to conventional banking? What are the effects of the bank characteristics on Islamic and conventional banking?

Chapter 2 Literature Review

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Literature Review

Many of the commercial banks like Citibank, NatWest, HSBC, Lloyds TSB etc have created specific cells to cater to the growing popularity of Islamic Banking. The potentials of Islamic banking have attracted the attention of such conventional banking giants. There are more than 300 Islamic banks all over the world and they are still expanding. In 2005 Lloyds TSB announced that it is going to expand its Islamic cells as there is a high demand for such accounts (Shakra; 2005). This becomes more beneficial to the consumers as well. For the evaluation of bank operations, it can be considered important to study the profitability index of the bank to determine different strategic and management planning analysis. Effective functioning of banks contributes a major factor for economical growth. Hence when a bank performs outstandingly, the overall economy of the society will be strong. There is abundant research conducted on the profitability of banks. Short (1979) had done a study on the relation between the profit rate of the banks and the concentration of banks in Canada, Western Europe and Japan. He took into consideration 60 banks over 12 countries during the 1970s. In his study he incorporated variables that were independent in nature and unique to each of the banks and the country. A few of these variables were government ownership and concentration with the help of H index to quantify concentration. Findings show that among the countries studied the impact of government ownership on profitability is varied. However the overall impact shown was negative. He also found that high profit rates are lead by higher concentration. (Short; 1979)

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Later in 1989 Bourke analysed the internal and external factors affecting the profitability in the banking industry, giving much focus on concentration as well as other variables. He considered a total of 90 banks within Australia, Europe and North America which comprised of approximately 12 territories between the period of 1972 and 1981. He divided the determinants based on internal and external factors. The internal factors comprised of staff expenses, capital ratio, liquidity ratio and loans to deposit ratio. The external factors included regulation, size of economies of scale, competition, concentration, growth in the market, rate of interest, ownership of the government and the market power. In his paper he also talks about regulation and also shows its identification in different countries with the help of a matrix as well as by stating the differences in entry barriers, interest rate restrictions and credit ceilings. He had also spoken about the structure of the industry, avoidance of risk, value added measures and the economies of scale. His findings correspond to that of Short (1979). As Short he also found that government ownership has a negative correlation on the banks profitability. Over and above this it was also found that interest rates, concentration and money supply have a positive correlation with profitability. It was also shown that profitability has a positive impact on capital and reserves of total assets as well as cash and bank deposits of total assets. In addition Bourke also stated that sufficiently well capitalized banks have access to cheaper sources of funds than the less capitalized ones due to the fact that the level of risk is less. (Bourke; 1989) Later using the Bourkes research as the basis, Molyneux and Thornton in 1992 analysed the profitability in European banks. They took into consideration 18 countries within Europe between the period of 1986 and 1989. The sample reviewed by them included 671 banks in 1986, 1063 in 1987, 1371 in 1988 and 1108 in 1989. Their findings were that the government ownership responds positively to return on capital (which in other words is profitability). This result however was contradicted the findings derived from Bourkes (1989) work. The other derivations were analogous to that of Bourkes which stated that there is a

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positive relation between concentration, interest rate and money supply and bank profitability. In the recent times there have been a lot of studies conducted around the profitability of banks involving many more determinants which have impacted the profitability. The other determinants used were bank size, degree of diversification, managers attitude towards risk, type of ownership and competition in banking industry. Thus if the size of the bank is large then they would have more access to funds and hence are more efficient than the smaller banks. (Berger and Humphrey; 1997) Ben Naceur (2003) examined the profitability of banks in Tunisia. He used the variables such as Return on Assets (ROA) and Net Interest Margin (NIM) to find out the profitability of the Tunisian banks during the period 1980 and 2000. As used in the other studies, Ben Naceur also used internal and external variables. The internal variables used by him included overhead expenses, total assets capital ratio and loan and equity ratio. The external variables utilized were macroeconomic factors such as GDP, growth, inflation and financial structure. He concluded the following: The bank interest rates within the country vary due to the characteristics of the individual banks. Banks that have a huge amount of capital and large overheads are usually characterised by the high interest margins and profitability. He also found that macro-economic indicators such as inflation and growth rates have no impact on their interest rate and profitability. It was also concluded that bank conce3ntration is less beneficial than competition for commercial banks in Tunisia. He also found that the growth of the stock market has a positive effect on the profitability of the banks. Goddard, Molyneux and Wilson (2004) wrote the latest paper on profitability in the European banks. Their study was on Eu ropean banks in 1990s and was done with the help of cross sectional and dynamic panel analysis. Their findings
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are analogous to those by Molyneux and Thornton (1992). They studied the details of six European countries which included Denmark, France, Germany, Italy, Spain and United Kingdom. 665 banks in these countries were covered for their study between the period of 1992 and 1998. For their analysis of regression they used variables such as included Return on Equity (ROE), logarithmic of total assets, Off Balance Sheet (OBS) dividends, Capital to Asset Ratio (CAR). Comparing the results to that of Molyneux and Thornton (1992), it was very much similar. It can be said that size and profitability hold a positive relationship between them, whereas OBS holds a positive relation with profitability for banks in UK and a negative or a neutral relation for banks in other parts of Europe. After his research he also stated that CAR beholds a positive correlation with profitability. He also established that ownership and profitability are not linked to each other as much. Spathis, Kosmidou, and Doumpos (2002) had done a study on Greek banks. They examined the effects of the small and large banks in Greece with the help of ratios such as ROA, ROE, and Net Interest Margin (NIM) as the measures of profitability. He examined a total of 23 banks out of which 16 banks were small banks between the time period of 1990 and 1999. The uniqueness of this article is that the researcher has separated the large banks from the small ones before measuring profitability. He concluded that the larger the banks the better access they have to resources and higher their ROA is. However the small banks showed a higher ROE and NIM as compared to that of the large banks. The smaller banks also showed a higher capital adequacy and financial leverage as compared to larger banks. A paper by Hassoune (2002) shows the volatility that the Islamic banks face in respect to profits using the Return on Equity (ROE) as a measure of its efficiency, whereas he used Return on assets (ROA) as a measure to check the profitability of Islamic banks. ROE is generally used to measure the efficiency of a firm as it relates directly to the equity of the firm. The earnings that the firm shows divided by the equity of the firm gives us the ROE.
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Prior to this Bashir in 2000 studied how the Islamic banks in Middle-East perform using internal and external variables. He found that the increase in the capital and loan ratios have a positive response to the profitability of Islamic banks. He also found that the promotion of bank profits is characterized by the customer and short-term deposits, non-interest earning assets and overheads. In the end he also concluded that the performance of the banks can be determined by the tax factors. Thus, the performance of Islamic banks is distorted by the financial health that is indicated by the inverse and statistical effects of taxes. However in 2004 both Bashir and Hassoune together examined the determinants of the profitability of Islamic banks with the help of Bank characteristics, financial environments and macroeconomic factors. He established that increase in capital has a positive correlation with the Islamic banks profitability measures, whereas loan ratios have a negative correlation. The results thus showed that larger the equity to total asset ratio, more is the profit margin. Their findings are in accordance with Bashir (2000). This thus shows that there is not much change in the profitability of Islamic banks. Taking into consideration the literature available on bank profitability in Europe and North America, it can be said that there have been a few. Some of them are mentioned below. Short (1979) analysed the relationship between the profit rates of commercial banks and the concentration of Canadian, West European and Japanese banks. In his paper he took into consideration sixty banks spread over twelve countries. The data analysed was for the year 1970s. His study comprised of variables independent in nature which were exclusive to each bank or country. These included government involvement. He also quantified concentration using the H index. The results obtained mentioned that overall government ownership had a negative relationship on the profitability though it varied from country to country. (Short; 1979)

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Due to the absence of the interest factor, Islamic banking is assumed by many to have high level of financial risk. As Islamic banks function on the basis of profit and loss sharing, the risks which the bank takes will eventually be shared by the investors as well, as stated by Dar and Presley (2000). In the year 2000 Bashir considered the performance of 8 Middle Eastern countries. By placing a control on the economic and financial structure measures he examined the significant characteristics of the bank that affected the Islamic banks performance. He took into consideration 14 banks across 8 countries between the years 1993 and 1998. He analysed the profitability using non interest margin (NIM), before tax profit (BTP), return on assets (ROA) and return on equity (ROE) as factors indicating their performances. He also included various internal and external factors in his study. The internal factors that he took into consideration were size of the banks, leverage, loans, short-term funding, overheads and ownerships; whereas the external factors were macroeconomic environment, regulation and financial markets. His findings confirm whatever was done in the previous studies and states that the profitability of Islamic banks has a positive correlation with equity and loans. This thus proves that Islamic banks with high loans and equity are highly profitable. Hence with a higher level of leverage the profitability of Islamic Banks increases. It can also be said from the findings that profitability is helped by certain favourable macro economic conditions. (Bashir; 2000) Hassoune (2002) points out that compared to conventional banks, the management of the Islamic banks have to generate more amounts of returns for their investors since they would not accept a state where no returns are provided. These findings were based on a comparative study of the ROA and ROE volatility of Islamic and conventional banks. (Hassoune 2002) Bashir and Hassan (2004) studied the profitability of 43 Islamic banks where they used net-non interest margin, ROA, ROE and many other variables. Their findings illustrated that Islamic banks have a better capital asset ratio compared

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to conventional banks, hence stressing on the fact that Islamic banks are capitally sound. There are a few empirical studies on Islamic banking in Malaysia. However the empirical articles are limited to Bank Islam Malaysia Pte (BIMB). The efficiency in the received sources and eventual use of bank funds were noticed to be high in productivity and managerial efficiency at BIMB. Samad (2000), in his research pointed out that conventional banks have been far more efficient in terms of its management as compared to Islamic banks. This state could also be reflected in BIMBs case since it had lesser fund utilization and profit generation than the conventional banks (Rosly and Abu-Bakar; 2003). It can thus be argued that if the managerial efficiency is poor and profits lower than the consumers might not be benefiting much from these banks. It would be a better option for customers to deal with conventional banks than Islamic banks. As in Islamic banks there is always a risk of losing money as you have to share the loss as well as per the Sharia. As from Elliot et al. (1996) price is an important factor while looking out for loans. (Devlin; 2002) Now-a-days people buy houses on mortgages only. There are a few people buying houses without any finance. Since the interest payment makes a huge difference in the monthly payment, consumers closely check the rates before accepting the loans. In the UK the conventional banks offer interest rates which are typical i.e. the interest rate keeps fluctuating. It is not a fixed rate. Thus it becomes difficult for customers to gauge the amount of the EMI for the next year and so future planning becomes difficult. In the case of Islamic banking, there is no factor of interest. They only take the future value of the house and divide it by the no of months. This monthly payment doesnt change. It remains the same whatever the case may be. Thus it becomes easier for the customer. As per the Sharia law the bank cannot make their investments in businesses like Gambling, Pork producing and Alcohol businesses. These businesses are high

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profit earning businesses. In theses business the Islamic Banks loose a share and the conventional banks have an upper hand. The conventional banks make a huge profit margin in these businesses. Thus businessmen investing in such businesses have to approach the conventional banks which prove beneficial for them. However as mentioned with conventional banks opening their Islamic banking cells, the original and authentic Islamic banks face a lot of competition. Muslims cannot even bank with the Islamic banking cells of the conventional banks as they are not sure where the investments are made and how their money is used. It could be possible that theses finances are used in businesses forbidden by the Sharia law. Thus there are so many areas in such cases which are not yet researched. Islamic banks also give the consumers the option to decide where their money is to be invested. They have two types of investment accounts: one where the depositor authorizes the bank to invest the money in any project and the other where the depositor has to mention his choice of projects. With these investments the profit ranged from 9 - 20 percent which was competitive with the conventional banks. (Khan; 1983) Nienhaus (1988) suggested that the profitability of the Islamic banks in the Middle East in the recent years was due to the property (real estate) boom. Once the property sector crashed there were huge losses that the Islamic banks had to bear. In his work Arrif also noticed that the most common feature is that the deposits made by the Islamic banks were all mainly on a short term basis. This is due to the fact that the banks want to keep the preference of the depositors for assets in liquid form as far as possible. Even in Malaysia where investment deposits account for a huge portion of the total, were made for a period which was less than two years. This helps the banks in keeping the assets in a liquid for m for the depositors. However when comparing this with conventional banking, the

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banks invest on a long term basis as these have a higher rate of return thus earning a higher profit for the banks. To conclude, it can be said that there have been numerous studies done on the profitability of banking by various authors, be it conventional banking or Islamic banking. Studies have also shown that Islamic banking profitability is not inferior to that of conventional banking. Islamic banking as the conventional banking system should be viewed as another kind of banking. It has showed a tremendous progress since its invention. It is also seen that the Islamic banking is a very practical way of intermediation. In the following chapter the methodology of data collection will be reviewed so as to show the ways and means of acquiring the information.

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Chapter 3 Methodology and Data Collection

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Methodology and Data Collection

This section deals with the ways and means of collecting data. The collected data can be used for the purpose of creating a valuable decision on the profitability of Islamic banking as compared to the other convention banking systems. It addresses the important characteristics of the bank that will be used in the regression models. The ordinary Least Square Method will be used to check the impact of bank characteristics on bank profitability. The methodology adopted would observe the sensitivity of internal bank characteristics on the indicators of profitability. The study of profitability is conducted on the Islamic banks in the GCC network and is also compared with the conventional banks in that region. The methodology begins with collection of data samples and then moves onto variable definition, model and data variables which are followed by graphs on ROA and ROE.

3.1 Data Sample

For this dissertation the data has been collated from financial statements available in Bankscope. This database gives complete information on banks. Data has also been taken from financial journals available online, as well as articles written by previous researchers of Islamic banking. The data on Islamic Banks and their functioning is also taken from academic books available in the vast resources of Coventry Universitys library. Within the GCC network it has been identified that there are two kinds of banking operations namely Islamic and Conventional. The study undertaken compares sixteen Islamic Banks to eighteen conventional banks. The collected data examines profitability between 1997 and 2004.
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Regression analysis is carried on to determine the profitability of both the Islamic and Conventional banking so as to compare them. Regression analysis is a statistical tool which analyses the relationship between two variables. Usually it helps in ascertaining the effect of one variable on the other. Many previous studies have used Return on Assets (ROA), Return on Equity (ROE), and Net Interest Margin (NIM) as profitability indicators to predict the profitability of a certain sector or company. However to predict the profitability of the banking sector in the GCC these three variables have been supported by other independent variables. The independent variables that are used in the regression analysis are Total Assets (TA), Total Equity to Total Assets (TE/TA), Total Loans to Total Assets (TL/TA), Deposits to Total Assets, Total Expenses to Total Assets and Non-Interest Expense to Total Expense. These variables have been selected on the basis of previous researches done. The details of these variables are explained further in this chapter.

3.2 Variable Definition

The explanation of the nine variables used in the regression analysis is explained in this section. Out of the total of nine variables used in the analysis, three are dependent and the remaining six are independent. The dependent variables are ROA, ROE and NIM whereas the independent variables are Total Assets, Total equity, Loans, Deposits, Total Expenses and Non-Interest Expenses. The dependent variables such as Total Assets, Total Equity to Total Assets (TE/TA), Total Expenses to Total Assets etc do not require any other variables to support in their analysis. They directly relate to a particular conclusion. For example take into consideration the variable Total Assets of a bank; this will help in determining the size of the bank. However while considering independent variables like ROA, ROE and NIM, it is required that dependent variables like Total Assets support them in identifying the performance of the banks.

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3.2.1 Dependent variables Return on Assets (ROA) Return on Assets (ROA) is used to indicate the profitability of banks. ROA which is calculated by dividing net income by total assets gives a ratio of the earnings which is generated from invested capital. ROA is management effective in generating profit on each dollar of investment (Hassoune; 2002). Since the ROA measure the asset performance of the company, it is given a lot of importance in the banking business. Bashir and Hassan (2004) and Ben Naceur (2003) both have included ROA in their study as an indicator of performance as well as a dependent variable. In this study, ROA is a dependent variable as it facilitates the identification of the effectiveness of Bank assets. Return on Equity (ROE) Return on Equity gives an indication of the profit generated by the bank from the money that the shareholders have invested in the company. The calculation of ROE is done by net income and the shareholders equity. ROE is also an indicator of the efficient use of the shareholders funds by the bank management (Hassoune; 2002). In their study, Bashir and Hassan have made a use of ROE. This ratio also forms a part of this study as a dependent variable due to the fact that the use of this ratio will highlight the efficient use of shareholders funds. Net Interest Margin (NIM) The difference between the income that the bank earns from interest charged by the bank and the expense that the bank incurs in giving interest to the depositors is the Net interest margin. Net Interest Margin is always expressed as a percentage of average earned assets. The profitability of the bank in terms of loans is measured by NIM. However, in the case of Islamic Banks the NIM would measure profits from the interest free lending carried out by the bank. It will thus make the data more dependable with the other banks. Ben Naceur (2003) in his studies took NIM as a performance indicator. NIM establishes the profitability of
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bank lending and is thus used in the study profitability. NIM is taken as a dependable variable while studying the profitability of Islamic Banking.

3.2.2 Independent Variable Total Assets (TA) The companies valuables are termed as Total Assets. This includes tangible assets such as equipment, property, land, machinery etc as well as intangible assets such as goodwill, patent etc. in the case of banks the total assets mainly relate to the loans that the bank has given to their customers, which form the basis of banking operations whether it be through interest free or charging the interest. Total assets of the bank corresponds t the size of the bank. Thus banks with a higher total asset will be huge in terms of the size of the bank. Goddard, Molyneux and Wilson (2004) have taken into consideration the total assets of the banks for their study of profitability of banks in the European nations. In their study they have found a positive relation between the total assets and profitability. As the total assets determine the magnitude of the bank size, it has been included in this study. Instead of dollars, the total assets have been converted in to logarithms so as to make t=it more consistent with the other ratios. As bigger banks tend to be more profitable as compared to the smaller ones, total assets have a positive relationship with profitability. Total Equity to Total Assets (TE/TA) The adequacy of bank capital is measured by total equity over total assets. This ratio is a sign of the ability that the bank has to absorb the losses incurred and to handle risk exposure with shareholders. Previous studies that have been done on profitability show that there is a positive correlation between TE/TA and the profitability of banks (Hassan and Bashir; 2004). TE/TA is thus taken in to consideration in this study as it discovers the capitalization of banks as well as the ability that the bank has to handle the losses with the shareholders. TE/TA is
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thus anticipated to have a positive relation with performance as banks that are capitalized in good health are much more profitable and less risky (Bourke; 1989) Total Loans to Total Assets (TL/TA) The liquidity of the assets of the banks in relation to the loans can be measured with the ratio TL/TA. The higher the TL/TA ratio the less liquid the bank is. Though Islamic banks operate on a profit and loss basis which is interest-free lending, most of the operations of the banks depend on loans to a great extent. Studies that have been done in the previous years on the conventional banks claim that TL/TA and profitability are positively related to each other (DemirgucKunt and Huizinga, 1997). In this study TL/TA is used as an independent variable so as to compare the interest loans from conventional banks and the interest-free lending offered by Islamic banks. Deposits to Total Assets The ratio of the deposits in the banks to the Total Assets; which is considered as a liability is another indicator of liquidity. The impact of the liabilities of the banks on its profitability can be measured by this ratio and is thus used in this study. One of the main source s of bank funding is deposits. It is thus included in this study as an independent variable so as to compare it with other ratios by dividing deposits with the total assets of the banks. In the study done by Bashir and Hassan (2004) deposits were incorporated finding a negative relation with the profitability. Total Expenses to Total Assets In terms of Conventional banks, the interest given on the deposits made by customers mainly constitute the expenses of the bank. For the ease of comparison, total expenses are converted into a ratio format by dividing by the total assets. It is assumed that the ratio Total Expenses to Total Assets has a negative impact on the profitability. Thus to scrutinize the impact that expenses have on the profitability, this ratio is used in the regression analysis. However it is
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astonishing to notice that in the study done by Ben Naceur (2003), there was a positive relation with profitability. Non-Interest Expense to Total Expense Total expenses of the bank excluding the expenses of interest constitute noninterest expenses. To determine the effect of interest on expenses non-interest expenses are divided by the total expenses. This ratio mainly corresponds to the overhead expenses. In the comparison of Islamic banks and conventional banks this ratio is taken as an independent variable. However it has been noticed that this ratio is not used in previous studies done by authors.

3.3 Models Used

To observe the profitability of Islamic banks and to compare it with Conventional banks, the use of Ordinary Least Square Method; a normal regression equation is done. The three dependent variables used in this study are ROA, ROE and NIM. These would determine the profitability of Islamic as well as Conventional banking. The other variables are used as independent variables. The models that have been considered for this study are mathematically represented below. Model 1 ROA ( )

Model 2 ROE ( )

Model 3 NIM ( )

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Where, Represents the Return on Assets for bank b in the year t, Represents the Return on Equity for bank b in the year t, Represents the Net Interest Margin for bank b in the year t, Represents alpha (constant) for each model respectively, represents the coefficients of the regression equation, ( ) Represents the logarithm of total assets for bank b in the year t,

Represents Total Equity to Total Assets for bank b in the year t, Represents Total Loans to Total Assets for bank b in the year t, Represents Deposits to Total Assets for bank b in the year t, Represents Total Expenses to Total Assets for bank b in the year t, Is for bank b in the year t, Represents an error term. The next section gives a descriptive statistical representation of the data collated from the resources mentioned above.

3.4 Data Variables

As per variables discussed in the earlier section, this section would give a descriptive statistics. Some of these are mean, median, maximum, minimum and standard deviation. The statistical representation of the total sample which includes Islamic as well as conventional banks is shown in the Table 3.1 below. Within the same table separate statistics for Islamic banks and conventional banks is also shown.

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Table 3.1 Descriptive Statistics

Source: Constructed using the data available in Bankscope.

The table below shows the facts and figures of Islamic and conventional banks in the GCC. As per the table it is seen that considering the total assets of the banks the amount of conventional banks in GCC is much more than Islamic banks. It is approximately double the amount of Islamic banks in GCC. The ROA of conventional

banks is lower as compared to Islamic banks, whereas the ROE is higher.

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The mean of Islamic banks is 2.82% which is lower than that of the conventional banks which is at 3.11%. Consider deposits, total expenses and non-interest expenses and it is noticed that conventional banking is almost double the size of Islamic banking. Islamic banking shows a higher capital indication while checking the TE/TA ratio which only suggests that the comparatively Islamic banks are much well capitalized. However the TL/TA ratio shows that conventional banks are more liquid as compared to their Islamic counterparts as the Islamic banks have a higher ratio. It is also noticed that the standard deviation for all the variables of Islamic banks is high. This means that Islamic banking variables encounter a higher divergence. However Islamic banks showed a lower standard deviation of expenses concluding that their expenses are more stable as compared to conventional banks.

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Figure 3.1 ROA of Conventional and Islamic Banks

Figure 3.2 ROE of Conventional and Islamic Banks

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Chapter 4 Findings and Results

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Findings and Results

The results for the profitability determinants between the period of 1997 and 2004 for the GCC banks are presented in this part of the dissertation. It

commences with a comprehensive ratio analysis of the banks. Various categories such as asset quality, capitalization, operations and liquidity are outlined by comparing these ratios. The ratio comparison is numerically represented in a chart. Eventually an analysis of the correlation of variables is done. The relation amid the characteristics of the bank is tested by this correlation. ROA, ROE and NIM are the three dependent variables that are utilized in the regression analysis. The regression will test the influence of the bank determinants of profitability on the dependent variables. Above all the

profitability study helps in comparing Islamic and Conventional banks and identifying their strengths and weaknesses. The similarities between the GCC banking consider all the countries within that council as one country. The regression analysis and correlation have been divided into three parts. The first part comprises of the variables of Islamic and Conventional banking combined. The second contains just the variables of Conventional banking in the GCC. The third is the variables of Islamic banking in the GCC.

4.1 Ratio comparison of Islamic and Conventional Banking

Herein some of the ratios of the Islamic and the conventional banking in the GCC are compared. With the help of certain important performance measures, both the Islamic and the conventional banking are compared in Table 4.1. Within this ratio comparison 16 Islamic banks and 18 Conventional banks are taken as a sample. The size of the banks is similar as they operate side by side in GCC.

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The ratios given in the table below are average percentages from 1997 to 2004. The ratio table is divided in to four parts namely asset quality, capital, operations and liquidity. Table 4.1 Islamic and Conventional Bank Ratios (1997 2004)

Source: Bankscope
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4.1.1 Asset Quality The Asset Quality analysis determines how likely the borrowers are to pay back the loans. The ratio Loans Loss Reserve to Gross Loans explains the banks possible losses in respect of the loans given, which have not yet occurred. In the GCC, conventional banks have a poorer ratio, thus stating that they have a healthier loan portfolio. The next ratio, Loan Loss Provision to Net Interest, quantifies the relation that provisions hold with interest income. This ratio is assumed to be kept as low as possible. While reviewing this ratio for the sample banks in the GCC, it was seen that the Islamic banks had a lower ratio. The next ratio, loan loss reserves to impaired loans, measures the loan loss reserve in respect to the non-performing loans. With respect to the sample banks, it is seen that for Conventional banks this ratio is high. This only summarizes to the point that conventional banks have a healthier asset quality with reference to the loan loss reserves. The forth ratio, Impaired Loans to Gross Loans, gauges the default rate of the loans. For the conventional banks in GCC this ratio is lower than that of the Islamic bank which is good for the conventional banks. Net Charge Off (NCO) to Gross Loans, which is the next ratio, percentage of total loans written off from the Loan Loss Reserves. It is noticed that the conventional banks have a healthier ratio as compared to the Islamic banks. The last ratio in the asset quality test is the NCO to the net income before the loan loss provisions. This ratio helps us measure the ratio that charge off have against the income, which ideally should be low. Even within this ratio the conventional banks show a lower percentage as compared to the Islamic banks. It can thus be concluded that conventional banks in the GCC have a better asset quality as compared to Islamic banks. 4.1.2 Capital The next part of the above given table compares the capital ratios of Islamic and conventional banking in the GCC. The capability of a bank to absorb the losses by giving a historic figure is calculated using the capital adequacy. Capital ratios

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are used by the Banking Supervisory Board (Basle) to calculate the ability of the bank towards risk exposure. The banks are encouraged on many instances to maintain an eight percent capital-asset ratio by the Basle Committee. Within the GCC both Islamic and Conventional banks are noticed to maintain a percentage that is higher than 8. However when researched, it was seen than the ratio is higher for Islamic banking. In their study, Bashir and Hassan (2004) also found Islamic banks to have a higher ratio though it was for a different sample. Equity to Total Assets, which is the first ratio, measures whether the bank has the capability to handle the losses with their shareholders. In the GCC Islamic banks have a higher ratio than conventional banks. The second ratio, Equity to Net Assets, quantifies the equity cushion available to withstand losses on the loan book. This ratio is higher for Islamic banks. The next ratio is the Equity to deposits and Short Term Funding. This compares the funding that the bank has on a permanent basis to the short term ones. For banks that are stable this ratio must be higher. Islamic banks have a higher ratio than conventional banks. The next ratio Equity to Liabilities, quantifies the equity funded to the bank compared to the liabilities of the bank. On the whole, it is noticed that the Islamic banks in the GCC are well capitalized as compared to the conventional banks of similar size. 4.1.3 Operations The banking sector involves a number of operations and many of them involve risks in the market. The operations ratios stated above point to the efficiency and soundness of banks. The banks that perform well generally have a high operations ratio. Net Interest Margin, one of the operations ratios, helps us specify the lending income shown in the form of a percentage. This is one of the important ratios in this part. Conventional banks show a higher NIM which means that conventional banks in the GCC are more profitable and they maintain a better asset quality. Operating income to average assets, the next ratio, helps us identify the amount of other income like fees that justifies the banks total income.

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The subsequent two ratios are the major indicators of profitability. These ratios are Return o Asset (ROA) and Return on Equity (ROE). ROA measures the return that the company yields from the assets of the company. The better the ROA, more the profitability of the bank is. In the GCC Islamic banks hold a better ROA as compared to the conventional banks. ROE is the return made by the bank with the capital (equity) that the shareholders have invested in the banks. A high roe is good for a bank as it shows that the bank is stable and more profitable. Another vital ratio that the shareholder look at while checking the profitability of the bank is the Dividend Payout ratio. This ratio gives the amount of dividend that the company pays on each share. The dividend Payout Ratio for Islamic bank in the GCC is higher than the Conventional Banks and thus is better in this respect. Non-operating Items to Net Income represents the percentage of abnormal items to the net income of the bank. This ratio must be low for stable banks. As per the data it can be seen that Islamic banks are more stable with respect to the Non-operating items. The cost to income ratio is another operating ratio that is calculated in the study of profitability. This ratio represents the indirect costs incurred by the company to generate the income. The lower this ratio the better it is for banks profitability. The final ratio in operations, Recurring Earning Power, helps in understanding the effectiveness of the bank. The calculation for this ratio is done by dividing the profits after taxation by the

total assets and is represented in a percentage value. By and large it is analyzed that conventional banks have healthier operational ratios compared to Islamic banking, though Islamic banking showed a healthier ROA and Dividend Payout Ratio. 4.1.4 Liquidity The final part in Table 4.1 is the liquidity ratios. The solvency of the banks and their ability to meet debt as fast as possible is measured by the liquidity ratios. Since the variables of the liquidity ratios change very frequently, the liquidity ratios are monitored on a regular basis. The first ratio within this criterion is the interbank ratio. This ratio is a measure of the money that the bank lends to other
36

banks and the money that the bank borrows from other banks for its operations. This ratio is generally higher than a one-handed percent for liquid banks as it shows that a bank is a lender more than a borrower of funds. The interbank ratio shown by Islamic banks in the GCC is higher than that of Conventional banks specifying that the liquidity of Islamic banks is healthier. The next ratio, net loans to total asset, measures the percentage of assets that the bank has attached with loans. This ratio must low for liquid banks. Conventional banks demonstrate a better liquidity in this perspective. Liquid Asset to Customer and Short-Term Funding, accounts for sudden withdrawals by customers. This ratio is generally high for banks than are more liquid in nature as it demonstrate how the bank would meet the short term funding in the case of sudden withdrawals by customers. According to the Table 4.1 above, it is seen that the overall ratios of Islamic banks in the GCC are as good as Conventional Banks. However it is noticed that Islamic banks have worse asset quality as compared to the Conventional banks in the same region. It is also analyzed that conventional banks have a greater operational and liquidity ratio. Astonishingly, Islamic banks maintain a capital asset ratio of 14.43 as compared to 11.51 maintained by Conventional banks, whilst a minimum of eight percent margin is recommended to be maintained by the Basle Committee. When analyzing the four kinds of ratios mentioned above, it can be seen that Islamic banks have only a better capital ratio.

4.2 Correlation Analysis

The relation between the ratios that have been discussed in the earlier part can be tested with the Correlation Analysis. The correlation matrix will show the expected coefficient signs from the regression. Table 4.2 depicts the correlation matrix which has been divided into three parts. The first part gives the data for Islamic and conventional banks combined and the remaining two parts gives the data for them separately.
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Table 4.2 Correlation Matrix

* - Significant at 1% ** - Significant at 5% As per the table 4.2 (first part), the size of the banks is measured by Total Assets. Total assets have a negative correlation with ROA and NIM however it is noticed that there s positive correlation with ROE. The correlation demonstrates that the coefficient of regression for Total Assets is anticipated to be negative with ROA and NIM. However it is predicted to be positive with ROE. This means that bigger banks tend to have lower ROA and NIM, which is consistent with research done previously (Berger; 1987). The capital adequacy indicator, Total Equity to Total Assets (TE/TA), shows a significant positive correlation with ROA,
38

but it shows a negative correlation with ROE and NIM. As per the research done earlier it is seen that there is a positive relation between the performance of the bank and its capitalization (Dermerguc-Kunt and Huizingua, 1999). Total Loans to Total Assets (TL/TA) which is one of the liquidity indicators, shows a negative correlation with ROA. However it shows a positive correlation with ROE and NIM. This advocates that the NIM and ROE rises with the rise in bank loans. However it is analyzed that Deposits to Total Assets illustrates a positive correlation which is insignificant with all the profitability ratios. It is assumed that the Total Expenses of the bank affects the profitability unconstructively. However as per the analysis it is witnessed that there is a positive correlation between the Total Expenses and the ROA. This infers that higher expenses lead to larger returns. This could propose that the banks in the GCC might not have many expenses and thus must concentrate more on activities to attract profits. NonInterest Expenses to Total Expenses is anticipated to have a direct relation with performance as it is by and large overhead expenses such as employee salaries. It is also noted that a large portion of the expenses of the bank is interest that they pay to the depositors. Additionally, the correlation table states that there is a direct correlation between the banks performance and the non-interest expenses, as stated in previous research (Bashir and Hassan; 2004) The second part of the table 4.2 is related to the correlation matrix of conventional banks in the GCC. As per the table it is seen that Total Loans to Total Assets for conventional banks has a positive correlation with ROA and a negative one with ROE. Alternatively NIM has a positive correlation with TE/TA and Total Expenses to total Assets and a negative correlation with Deposits to Total Assets. This further recommends that high interest incomes are associated with well capitalized conventional banks with high expenses. On the contrary, conventional banks which show high deposits have a lower interest income. The third and the final part of the Table 4.2 is the correlation matrix of Islamic Banks. This matrix shows that deposits and ROA are negatively related. This

39

points out to the fact that Islamic banks in the GCC with high rate of Deposits ratio have a low rate of returns. Additionally, it is also examined that Non-Interest Expenses of the Islamic banks in the GCC, have a negative effect on the profitability if the banks which ultimately contradicts the studies done by Bashir and Hassan (2004). This section thus gives a preface to the analyses of the correlation between variables putting across different signs. Correlation involves relation between the variables and may perhaps not stand for cause. Nevertheless the correlation analysis in general has similar signs as the correlation matrix. Hence the next section which is the regression results discloses the results in addition to comparing it with other findings and drawing a much more concrete conclusion on the determinants of profitability for the Islamic and conventional banks in the GCC.

4.3 Regression Results

Regression analysis can help in predicting the outcomes of a given important business indicator, in this study the profitability indicator, based on the interactions of other business drivers. In this study profitability of Islamic and conventional banks is determined with the help of explanatory variables like Total Assets, Total expenses to Total Assets, TE/TA etc. For the regression analysis, the section has been divided into three parts. The first part deals with the results of the entire sample which is the combined results of Islamic and Conventional banks. The second and the third part concentrate on the Conventional and Islamic banks respectively. Multiple-regression has been applied to estimate the determinants of profitability for both Islamic and conventional banking. While analyzing the regression, Islamic and Conventional banking in the GCC has been treated as one country as they show similarities.

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4.3.1 Aggregate Sample Regression Analysis Table 4.3 shown below indicates the results of the regression of both the Islamic and Conventional banks. According to the model, there are three different dependent variables namely ROA, ROE and NIM. Table 4.3 Regression results of the complete Sample.

ROA conveys a significant positive correlation with the logarithmic of Total Assets, Total Equity to Total Assets and Total Loans to Total Assets. This helps us to understand that large banks in the GCC have high Returns on Assets. Spathis, Kosmidou and Doumpos (2002) in their research also found that total assets (bank size) and ROA are positively related which is consistent with this findings. On the contrary considerable equity and loans of the GCC banks lead to high ROA. Moreover it is also seen that both deposits to total assets and total expenses to total assets show an insignificant positive link with Return on Assets

41

(ROA). At last, Non-Interest Expenses to Total Expense shows a considerable positive correlation with ROA. This is a sign stating that overhead expenses such as ATM costs etc add to the performance of the banks. On the whole, these variables influence the ROA by 41.2% of which non-interest expenses covers the highest coefficient. ROE is the second model of regression. The independent variables associated with ROE have expressed almost the same coefficient as the ROA except TE/TA and Deposits. TE/TA shows a significant relation of positivism with ROE. This specifies that increased issue of equity triggers a low return on equity, which means lower efficiency with respect to shareholders investment. However Deposits showed a negative impact on ROE though it was significant at 10%. NIM is the third model of regression. The variables of regression expressed comparable signs as expected in the correlation matrix. In other words it can be said that NIM in the first part of Table 4.2 demonstrated similar sign with the variables in the correlation matrix as for the coefficient. As a result, the coefficient of Total Assets specifies that small size banks have a larger NIM. Spathis, Kosmidou, Doumpos (2002) concluded the same that larger NIM is associated with smaller banks, which is consistent with the findings in this research. Thus it can be said that small banks are more profitable that their larger counterparts in respect of NIM. However, due t the fact that larger banks are much more well capitalized than the smaller ones; they are less likely to fail (Boyd and Runkle; 1993). Furthermore it is seen that all the variables have a significant relation with NIM except for Total Expenses. In addition, the r squared adjusted for the model is shown at 35.4%.

4.3.2 Conventional Banking Results Analysis Table 4.4 given below corresponds to the conventional banking in the GCC. The results in this table are compared to the results found by Ben Naceur (2003) in

42

his research. However in his studies ROA and NIM were the only variables that were dependent and profitability indicators. As per the ROA model it is seen that the variables show a positive correlation with the coefficients except for Total Assets and Total Expenses where it is negative. This is also consistent with the results of the study done by Ben Naceur (2003) except for total Expenses with ROA. The findings by the author Total Expenses and ROA show a negative relation between them. This could further advise that the banks might have to lower their expenses. Ben Naceur (2003) had found that expenses and profitability for conventional banks are positively related. Though Total Assets showed a negative correlation with profitability, it was insignificant. In the Table 4.2 part 2, the regression results showed similar signs to the correlation matrix except for Total Expenses.

Table 4.4 Conventional Banking Regression Results

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In the ROE regression results the identical bank characteristics were taken into consideration. As per the regression results there is similar results as the correlation matrix. However Total Assets which shows a negative insignificant relation is not consistent with the matrix. It can thus be inferred that larger banks tend to have a lower return on equity, which is contradictory to the correlation matrix. The constant which is significant at 36.42% points out that there could be other determinants affecting the ROE in the GCC. On the whole it can be seen that it is 24.2% conveying that the variables would justify ROE only to the effect of 24.2%. However the Total expenses coefficient is high indicating that the conventional banks incur a lot of expenses that is affecting the ROE and that it must be lowered. The third and the last model that has been used for the study of the profitability is NIM. The results of this model emerge as similar to the findings of Ben Naceur (2003). However as per the study done by the author, TE/TA shows a negative coefficient with NIM, though it is insignificant. This implies that the higher ratios of equity lead to lower interest income. However this is illogical as banks with high equity ratios are less reliable on debt (Ben Naceur; 2003). To conclude, it can is seen that except for TE/TA all the other variables are significant. The results of the regression are also consistent with the correlation matrix and that the rsquared is measured at 42.30%.

4.3.3 Islamic Banking Results Analysis Within this section, the results of Islamic banks in the GCC are discussed. The results, as shown in the table 4.5 would be compared to the findings of Bashir and Hassan (2004). The review shows that Bashir and Hassan used ROA and ROE as the indicators of profitability for their study. Further the results of the regression will be compared to the correlation matrix for NIM. ROA shows a positive relation with almost all the variables except for Deposits, though it is an insignificant relation. The analysis and findings of this research
44

confirms the results of Bashir and Hassan (2004). As per the analysis it is known that TL/TA, which is interest-free lending with respect to Islamic Banks, has a positive significant elation with ROA. However Bashir and Hassan stated that there is a negative relation with respect to loans and profitability. The overall Rsquared is at 52.4%, which is good for the Islamic banks.

Table 4.5 The Regression Results of Islamic Banks in the GCC.

By comparing ROE, the second regression model with the characteristics of the banks, it is noticed that there is variation in the coefficient signs. Excluding the relation with loans, the results in this research correspond to the findings of Bashir and Hassan (2004). TL/TA has a positive relation with ROE at a significance level of 1%. This thus infers that higher lending helps banks to create a higher return on its equity. However it is noticed that according to the findings of Bashir and Hassan (2004), there is a negative correlation between the bank lending and Return on Equity. On the whole ROE is explained by these variables at being 31.4%.
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NIM which is the third regression model is another indicator of profitability for the Islamic banks in the GCC. However they correspond to interest free lending carried on by the Islamic banks to the Sharia law. The p-values for some of the variables like Total Assets, TE/TA, Deposits and Total Expenses are greater than 10% and hence they are insignificant. While studying the variables it has been noticed that the variables positively relate to NIM except for Total Expense which has a negative relation. It is also noted that the results contradict the expectations set by the correlation matrix. According to the matrix Total Assets, TE/TA and Non-Interest Expenses were supposed to have a negative correlation with NIM. This recommends that large banks which are well capitalized and also have a high non-interest suffer a low NIM. However the variables have justified the profitability of the lending of Islamic banking (NIM) by 36.9%. On the other hand the findings of the research show certain differences form the findings of Bashir and Hassan (2004). The difference arising from both the studies could be due to the fact that the findings of Bashir and Hassan (2004) were done on the basis of a sample in another region and also included more Islamic banks. Towards the end it can also be said that non-interest expenses, Total Assets (size) and loans show a positive relation with all profitability indicators conforming that all the variables add to the profitability of the banks. To conclude, this chapter has reviewed a number of key internal bank characteristics which show either a positive or negative relation with the profitability indicators. The variables even show some significant and insignificant relations with the indicators of profitability. The results and findings in the chapter had been divided into three parts. The first part explained the variables for the whole of the sample which included the Conventional banks as well as the Islamic banks. The second and third part corresponds to the variables of Conventional banking and Islamic banking respectively. A ratio analysis has also been done comparing Islamic banking and Conventional banking prior to the results. The correlation is then analyzed expressing the relation among variables. The results obtained for the conventional banks were compared to the findings of

46

Ben Naceur (2003). The results obtained for the Islamic banks have been compared to the findings of Bashir and Hassan (2004). The next chapter gives the conclusions and recommendation of this research followed by a set of limitations.

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Chapter 5 Conclusion and Limitations

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Conclusion and Limitations

5.1 Conclusion
The aim of this dissertation is to identify the profitability determinants for the Islamic banks in the GCC. This is done for a period between 1997 and 2004. With the application of the regression analysis, the determinants of profitability for the Islamic banks have been compared to that of Conventional banks. Previous studies done by authors like Bourke (1989), Molyneux and Thornton (1992), Ben Naceur (2002) and Bashir and Hassan (2004) have been followed in the dissertation. The dissertation began with a brief overview of Islamic banking and its operations. Selected literatures from previous studies on the profitability of banks have been summarized and reviewed emphasizing more on the Islamic banks. The variables that have been used in this study have also been introduced. Later ratios have been compared between Islamic banks and conventional, the results of which proved similar. To the end, the regression analysis has been done which shows the influence of bank characteristics on profitability. The results that have been derived on the banking in the GCC were consistent with those of previous studies done by authors such as Bashir and Hassan (2004) for Islamic banks and Ben Naceur (2002) for conventional banks. The difference in the relationship between the characteristics of the bank and the profitability indicators are also demonstrated by the results. ROA, ROE and NIM are the profitability indicators that have been taken as dependent variables in this study. The variables used in the regression analysis have different reactions for Islamic and conventional banking. To begin with, it is noticed that Total Assets, which measures the bank size, shows a negative relation with conventional banks.

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However with Islamic banks in the GCC it has a positive relation. This infers that conventional banks that are large in size have a low profitability. Secondly, Total Equity, the measure of capitalization, shows a negative relation with the profitability of conventional banks but a positive relation with that of Islamic banks. This further indicates that the profitability of the Islamic banks is supported by the high capital ratios. Thirdly, Total Loans for the types of banking shows a positive relation with profitability, which deduces that lending activities improves the profitability of banking. Fourth, Deposits show a positive relation with profitability of Conventional banking and a negative relation with that of Islamic banking. This indicates that for conventional banks, Deposits helps in improving the profitability as against that for Islamic banks. Fifth, Total Expenses affects the profitability of Conventional banks negatively and Islamic banks positively. Finally, Non-Interest Expense assists in improving the profitability of both Islamic and Conventional banking.

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5.2 Limitations
There have not been any major obstacles during the study of the banks in the GCC. However, the data on the banking sector in the Middle-East is not easily accessible or reliable in general. The data for this research is taken from Bankscope. There were many banks that have been included in this study, which did not have the data prior to 1997. The data available on the Islamic banking gives an indicative result rather than a conclusive one as found in the research conducted previously on the Islamic banking sector (Iqbal and Molyneux; 2005) while analyzing the regression, variables with a high p-value have been

encountered. This means that these variables are insignificant in terms of the dependent variables. Some other variables have also not been included in this study to test the profitability of the banks. Some of these variables are GDP and inflation which has been used by Bashir and Hassan (2004). They found that favorable economic conditions have a positive effect on the profitability of the banks.

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Appendices

Appendix 1
Real GDP (Millions USD)

Source: Adapted from Arab Monetary Fund www.amf.org

60

Appendix 2
GDP Growth (%)

Source: Adapted from Arab Monetary Fund www.amf.org

61

Appendix 3
GDP Per Capita (USD)

Source: Adapted from Arab Monetary Fund www.amf.org

62

Appendix 4
Exports in the GCC (Millions USD)

Source: Adapted from Arab Monetary Fund Report (2005)

63

Appendix 5
Imports in GCC (Millions USD)

Source: Adapted from Arab Monetary Fund Report (2005)

64