0696

MBA THESIS
Comparing Islamic and Conventional Banking

Performance in Kuwait
Using the CAMEL Rating Method

BY

MOHAMAD FADI Ahmed
KUWAIT

A thesis submitted in partial fulfilment of the requirements for the degree of Masters of Business
Administration (MBA) of the Maastricht School of Management (MSM), Maastricht, and the
Netherlands

November 2008

MBA THESIS

THESIS TOPIC SUBMITTED BY:
Islamic banking and conventional banks
performance in Kuwait using the CAMEL rating
method

Mohamed Fadi Mohamed Hassen
Ahmed
SUPERVISORS NAME INTAKE AND GROUP NUMBER
Dr. Jonathan Intake 5 Group 2
STUDENT ID: COUNTERPART:
KW/KMBS/05/06/025
APP ID: 696
Kuwait
THESES SUBMISSION DEADLINE

SUBMISSION DATE
November, 19. 2008

November, 19. 2008

This statement should be completed and signed by the student producing the thesis.
Declaration and Statement of Authorship:

1. I hold a copy of this thesis, which can be produced if the original is lost/damaged.
2. This thesis is my original work and no part of it has been copied from any other students work or from any other
source except where due acknowledgement is made.
3. No part of this thesis has been written for me by any other person except where such collaboration has been
authorized by the supervisor concerned and is clearly acknowledged in the thesis.
4. I have not previously submitted or currently submitting this work for any other thesis.
5. This work may be reproduced, communicated, compared and archived for the purpose of detecting plagiarism.
6. I give permission for a copy of my marked work to be retained by the School for review and comparison, including
review by external examiners.

I understand that:

7. Plagiarism is the presentation of the work, idea or creation of another person as though it is your own. It is
considered cheating and is a very serious academic offence that may lead up to expulsion from the program.
Plagiarised material can be drawn from, and presented in, written, graphic and visual form, including electronic
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8. Enabling plagiarism is the act of assisting or allowing another person to plagiarise or to copy your work.

Last Name First Name Signature
Ahmed Mohamed

Source: This document has been adapted from http://mams.rmit.edu.au/7ksj9bbov094.doc

II
ACK NOWL E DGE ME NT

I would like first to thanks God for his pleasing, sustaining guidelines, and for all the
strength he gave me to carry on. Special thanks I forward it to my wife for all her love
and support, and my parents for their additional support to goes on.

I also express my grateful appreciation to my manager and close friend Mr. Mustafa
Abdou for his continuous support and enlightening throw the difficult times.

Most of all I thank Dr. Jonathan who made comprehensive, particularly useful and
remarkably speedy comments on every chapter, despite his many responsibilities at
Kuwait Maastricht Business School.

Finally, many thanks go to MSM staff whose has been outstandingly helpful in all
circumstances.

iii
ABST R ACT

This thesis examines the Kuwait banking performance with a comparison of Commercials and
Islamic banks. The model that had been used for this thesis is the CAMELS rating system.
CAMELS rating system is used worldwide as a tool to evaluate the Early Warning System
(EWS). The CAMELS rating system has been developed through extensive studies relates
towards evaluating the banking financial condition using the financial data of the banks. The
study here uses the data published by the Institute of Banking Studies in Kuwait (IBS). The data
extracted from these reports are towards the years 1999 to 2007. Nine banks were classified into
the conventional banks and two within the Islamic banks. The data was entered into SPSS and
various discriminant analyses were derived in addition to Kruskal-Wallis test. Since the IBS
data did not provide the sensitivity factor (S) of the CAMELS rating system and the Supervisory
method used by CBK is CAMEL Rating, to measure the local banks performance in Kuwait, the
Sensitively Factor (S) was discarded and only the remaining five factors were considered.

The focus of this study to found factors discriminate the Islamic banking among conventional
banks in Kuwait and to understand the financial conditions of the banks based on the available
historical data. Each of the five factors were indentified and discussed. The literature review
provides a strong background of the CAMELS rating system and its usages worldwide and in
Kuwait. Kuwait as of 2005 has started to use the updated version of CAMEL rating system as
per instruction from the Central Bank of Kuwait. The discriminant analysis revealed that both
conventional banks and Islamic banks had their respective strength with the CAMEL factors, but
on an overall the Islamic banks performed especially with a better rating on Earnings and
Liquidity and also Asset Quality. The conclusion has been discussed with the help of the
research questions. The recommendations provided were for the banks and the IBS. Future
study focused on collecting the data directly from the banks and also in doing a in-depth
qualitative study with the management of these banks.

iv
L I ST OF F I GUR E S

Figure: 1.1 Islamic Securities Growth Page 4
Figure: 2.1 Banking & Financial Structure Page 10

v
L I ST OF T ABL E S

Table 2.1: CAMEL Rating system and description Page 12
Table 2.2: Supervisory Risk Assessments and early waning Model Page 16
Table 3.2: Data taken from the secondary data Page 26
Table 4.1: Descriptive Analysis Page 30
Table 4.2: Case processing summary Page 30
Table 4.3: Tests of Equality of Group Means Page 31
Table 4.4: Pooled within-groups matrices / correlation Page 32
Table 4.5: Eigenvalue Page 32
Table 4.6: Wilks Lambda Page 33
Table 4.7: Functions at Group Centroids Page 33
Table 4.8 Standardized Canonical Discriminant Function Coefficients Page 34
Table 4.9: Structure Matrix Page 35
Table 4.10: Classification Results Page 35
Table 4.11: Ranking Page 36
Table 4.12: Test Statistics Page 38

L I ST OF ABBR E V I AT I ONS

Abbreviation Explanation
ABK Ahli Bank of Kuwait
BKME Bank of Kuwait and Middle East
BOUB Bobuan Bank
BUB Burgan Bank of Kuwait
CAMEL Capital Adequacy, Asset Quality, Management, Equity and Liquidity
CBK Central Bank of Kuwait
cBK Commercial Bank of Kuwait
CAGR Compound Annual Growth Rate
CCA Canonical Correlation Analysis
CEBSS Committee of European Banking Supervisors
DA Discriminant Analysis
DEA Data Envelopment Analysis
EWS Early Warning System
FDIC Federal Deposit Insurance Corporation

G10
Group of countries that have agreed to participate in the general
Arrangements to Borrow (GAB)
GDP Gross Domestic Product
GUB Gulf Bank of Kuwait
IBK Industrial Bank of Kuwait
KFH Kuwait Finance House
KIB Kuwait International Bank
KREB Kuwait Real Estate Bank
NBK National Bank of Kuwait
NBS National Bank of Slovakia
NIB Non Interest Bank
OCC Office of the Comptroller of the Currency
ROA Return on Assets
ROE Return on equity
SREP Supervisory Review and Evaluation Process
YOY Year Over Year

1
T ABL E OF CONT E NT S

Acknowledgement ...................................................................................................................................... II
Abstract ......................................................................................................................................................iii
List of figures .............................................................................................................................................. iv
List of tables ................................................................................................................................................ v
List of Abbreviations .................................................................................................................................... i
CHAPTER 1: INTRODUCTION ....................................................................................................................... 3
1.1: OVERVIEW ....................................................................................................................................... 3
1.2: PROBLEM DEFINITION...................................................................................................................... 5
1.3: RESEARCH OBJECTIVES..................................................................................................................... 6
1.4: RESEARCH QUESTION ...................................................................................................................... 6
1.5: RESEARCH METHODOLOGY ............................................................................................................. 6
1.6: THESIS STRUCTURE .......................................................................................................................... 7
CHAPTER 2: LITERATURE REVIEW ............................................................................................................... 9
2.1: Introduction ..................................................................................................................................... 9
2.1.1: Overview of Banks in Kuwait ..................................................................................................... 9
2.1.2: Kuwait banking structure ........................................................................................................ 11
2.2: BANK RATING SYSTEM ................................................................................................................... 12
2.3: CAMELS COMPONENTS .................................................................................................................. 15
2.3.1: Managements Role ................................................................................................................ 22
2.3.2: Profitability analysis ................................................................................................................ 22
2.3.3: Capital adequacy ratios ........................................................................................................... 22
2.3.4: Long term solvency ................................................................................................................. 23
2.3.5: Earnings and profit performance emphasis ............................................................................ 23
2.4: Case Study ...................................................................................................................................... 23
2.4.1: CAMELS rating ......................................................................................................................... 25
2.5 Literature GAP ................................................................................................................................. 25
2.6 Summary ......................................................................................................................................... 26
Chapter 3: Methodology ........................................................................................................................... 27
3.1: INTRODUCTION .............................................................................................................................. 27
2
3.2: PROBLEM STATEMENT ................................................................................................................... 27
3.3: RESEARCH OBJECTIVES................................................................................................................... 28
3.4: RESEARCH QUESTION .................................................................................................................... 28
3.5: Research methods ......................................................................................................................... 28
3.5.1: Secondary data ....................................................................................................................... 28
3.6: DATA ANALYSIS TYPES AND METHODS .......................................................................................... 28
3.7: SAMPLE COLLECTION AND DATA ANALYSIS ................................................................................... 29
3.8: SUMMARY ...................................................................................................................................... 30
CHAPTER 4: DATA ANALYSIS AND DISCUSSIONS ....................................................................................... 31
4.1: INTRODUCTION .............................................................................................................................. 31
4.2: DESCRIPTIVE ANALYSIS .................................................................................................................. 32
4.3: DISCRIMINANT ANALYSIS ............................................................................................................... 33
4.3.1: Equality of Group Means ........................................................................................................ 34
4.3.2: Correlation .............................................................................................................................. 34
4.4: CANONICAL DISCRIMINANT FUNCTIONS ....................................................................................... 35
4.5: KRUSKAL-WALLIS TEST ................................................................................................................... 39
4.5.1: Test Statistics .......................................................................................................................... 41
4.6: SUMMARY ...................................................................................................................................... 42
CHAPTER 5: CONCLUSION, RECOMMENDATIONS AND FUTURE STUDY ................................................... 43
5.1: INTRODUCTION .............................................................................................................................. 43
5.2: CONCLUSION.................................................................................................................................. 44
5.3: STUDY CONTRIBUTION TO CURRENT GLOBAL CRISES: ................................................................... 45
5.4: RECOMMENDATIONS..................................................................................................................... 46
5.5: FUTURE STUDY ............................................................................................................................... 47
References ................................................................................................................................................ 48
Appendix 1: IBS Data Report Format ........................................................................................................ 52

3

CHAPT E R 1: I NT R ODUCT I ON

1.1: OVE R VI E W
This thesis looks into factor distinguishing between Islamic banks and conventional, overall
efficiency and credibility of Islamic banks and conventional banks in Kuwait by using the
CAMEL rating system and discriminant analysis. The literature review chapter provides
information and guidance towards developing a comparative empirical study using historical
information of bank- level data. The CAMEL rating method is an internationally adopted rating
system for banks used by bank supervisory authorities towards rating their institutions
(investopedia.com, 2008). The CAMEL acronym stands for: (C: Capital adequacy, A: Assets
quality, M: Management quality, E: Earning capacity, L: Liquidity risk).

The CAMEL rating system is taken into account on the basis of these five important areas, which
helps discriminate and analyze the bank performance. CAMEL rating provides a measurement of
a banks current overall financial, managerial, operational and compliance performance. The
CAMEL rating was first introduced in 1980s, by US supervisory authorities, the concept
introduce a uniform system of rating a banking institution in the United States. It is based on
examiner assessment of a banking institution under certain supervisory agencies, example the
Federal Reserve System, Office of the Comptroller of the Currency (OCC) and the Federal
Deposit Insurance Corporation (FDIC). The same measure has been use by Central Bank of
Kuwait (CBK) as per the circular dated 16/10/2005 concerning the updating the CAMEL
methodology used in rating the banking performance (CBK, 2006). The CAMEL locates few
ratios for each acronym components that measure the Capital Adequacy, Asset quality,
Management, Equity, and Liquidity which measure the bank performance, and soundness. For
example, in order to assess the Asset Quality authorities look through the total amount of
nonperforming loan over total loan to measure delinquency and insolvency portion of total loans.

4

Out of the five components, the most important considered is the management quality (Cole &
Gunther, 1995). Management efficiency analysis refers towards the management quality.
Authorities analyze the efficiency of the management structure and the employees working with
the bank. The historical stability as well as the recent performance will be taken into account for
rating. Moreover, the liquidity will be analyzed for the banks ability to meet unforeseen deposit
outflows. Analysis will be done at the bank's funding sources as well as the liquidity of its assets
in determining this rating.

These five strategies components ratings subjectively weight and analyze the overall CAMEL
rating for the bank. Rating is then used by discriminant Analysis (DA) to determine the degree of
regulatory attention and resources that will be devoted to the bank. For example, it can reveal
information such as composite rating of one which is thought to indicate a strong bank that could
weather adverse economic conditions. A three-rated bank is thought to be at risk in an
unfavorable economic environment. In doing so, it would reveal banks that are considered in
danger of failing thus enabling to take preventive corrective actions in time.

Islamic banking is more popular due to products varieties, and culture perception. In the last five
years, Islamic finance has grown by 15 to 20 percent annually, with an estimated $270 billion in
assets by 300 Islamic banks in more than 25 countries. Taking into account both a countrys
Muslim population and Gross Domestic product per capita (GDP), the largest markets for
Islamic finance include Turkey, Indonesia, Saudi Arabia, the United States, Qatar, Kuwait and
United Kingdom. (Schmith, 2005) The highest growing markets are the United Arab Emirates,
Bahrain, Malaysia, Indonesia, and Pakistan, approaching continuous growth in the Islamic
finance sector is significant, some estimates suggesting that within eight to ten years as much as
half the savings of the worlds 1.5 billion Muslims will be in Islamic banks. This could represent
$905 billion in total assets in Middle Eastern countries alone. Muslims living outside of the
Middle East, represent an even larger population, including countries such as India, Indonesia,
and Malaysia, but also within developed countries including the United Kingdom, France,
Germany, the Netherlands, and the United States. Conventional financial institutions manage
5
$1.1 trillion in Islamic funds (Schmith, 2005). Moreover, according to the Islamic banking is
more popular due to products varieties and culture perception.
(Global Finance, September 2005.)

1.1 Figure: Islamic Securities Growth

(Global Finance, September 2005)

1.2: PR OBL E M DE FI NI T I ON
The increase of global demands of Islamic finance leads few local conventional banks to
diversify to Islamic banks to increase bank revenue by targeting those Non interest bank clients
(NIB) and to meet customer perception. For example on December 25, 2006, the shareholders of
KREB (Kuwait Real Estate Bank) amended the Articles of Association to change the name of
the bank. Subsequently, in June 2007, the bank received approval from the Central Bank of
Kuwait (CBK) to operate as an Islamic bank with effect from July 1, 2007 (TAIB, 2008).
Moreover, Bank of Kuwait and Middle East is in process of diversification into Islamic banking
6
after receiving necessary approval from the Central Bank of Kuwait (CBK) dated June, 2008
(ARAB Time, 2008). These changes call for understanding of the relative performance of
Islamic banking and commercial banking. Specifically, is Islamic banking more profitable than
conventional banking? The issue is of interest to stakeholders in view of the current global
financial crises. Investors will like to know in order to inform their investments decisions. The
depositors will like to know in order to have reasonable assurance of the safety for their deposits.
If indeed there is performance deference in profitability between Islamic and conventional banks,
it is useful to know what factors are influencing this difference.

1.3: R E SE AR CH OBJ E CT I VE S
The main objective of this study is to find factors discriminating the Islamic banks from
conventional banks and to indicate the relative impact of each factor.

1.4: R E SE AR CH QUE ST I ON

1. What factors discriminate between Islamic banks and conventional banks?
2. Which of those factors is more important in discriminating between the two banks
categories?
1.5: R E SE AR CH ME T HODOL OGY
This study purely follows the quantitative method with the help of publically available data from
Kuwait, relating to banks. In order to gather data and information, the chosen method of action
is to conduct literature as well as empirical studies. The empirical data is gathered from the
Financial Operating Report published by the Research Unit of the Institute of Banking Studies,
Kuwait for various years. Data for 11 years is collected from these reports and the data pertains
to capital adequacy, asset quality, management quality, earnings, and liquidity. Discriminant
analysis and K Independent samples analysis are generated from SPSS and discussed in chapter
4.

7
1.6: T HE SI S ST R UCT UR E

Chapter 1: The initial chapter will contain an overview of CAMEL and its usage within banks.
Problem definition discusses the problem that the research seeks to answer. Research objectives
is the aim of the study and research questions will be answered with a combination of literature
and empirical data towards the end of the thesis.

Chapter 2: The literature review chapter provides information regarding the CAMEL rating
system and the discriminant analysis, its evolution, usage and benefits in the financial sector.
Other sections discuss information pertaining to Kuwait banks. An overview of Islamic banking
is also provided for the reader to understand the difference between Islamic and contemporary
banks. Data collected here are from articles, journals and online resources.

Chapter 3: This is the methodology chapter and discusses the various methods deployed here
towards collecting the data. There are two types of data gathered literature and empirical.
Focus here is largely empirical data. The empirical data here is limited to industry reports of the
Institute of Banking Studies. The research department releases information such as Highlights
covering Assets, Equity, Loans, Deposits, Dividends and Profits from a cumulative perspective.
Further sections break these data into individual banks. A separate section provides statistical
information on Individual Islamic banks. Quantitative is the approach used in the empirical
study.

Chapter 4: The Data Analysis and Findings chapter is the results of the empirical data. Data
here will be analyzed using the CAMEL rating system and discriminant analysis. Each of the
five component of the CAMEL rating system will be broken down and analyzed between each
banks and then between Islamic and Contemporary banks. The analysis will be done using SPSS
(Statistical Package for Social Sciences). Each of the outputs will be discussed in their
respective sections.

Chapter 5: This is the final chapter and discusses the Conclusion, Recommendations and Future
study. The conclusion is the outcome of the data analysis done in the previous chapter. The
8
research questions will be taken here and answered. The conclusion will discuss if the research
objectives have been achieved. The recommendations section provides guidelines towards the
banks of Kuwait. The future study is a direction on what should be done to find out the impact
of this study and also regarding the stability and reliability of the banks in Kuwait.

9

CHAPT E R 2: L I T E R AT UR E R E VI E W

2.1: I NT R ODUCT I ON
Banks are dominant in the financial system, as a result of crucial role play in country economic.
Creating an early warning model was essential to measure the banks performance. Therefore,
researchers worked on finding tools to measure banks performance or predict banking failure.
For example, the majority of the Turkish banks during 1998-2002 periods have faced credit and
operation risk primarily from bad managements practices, lack of governance and lack of
regulation and supervision (Aktas et al. 2005).

According to the countries specific factors the early warning system and supervisory risk
assessment will be diverse. Which include scope and frequency of on-site supervision; the offsite
monitoring mechanism, the extent, nature and reliability of regulatory reporting; the availability
of other reliable sources of information; the availability of historical data on bank distress; the
level of technological advancement; and the availability of necessary budgetary and human
resources, etc.

2.1.1: Over view of Banks in K uwait
The Central Bank of Kuwait is governing supervisory organization at all banks in Kuwait. The
CBK make an effort to tightly establish atmosphere of monetary stability in the State of Kuwait,
and supporting the financial positions of the local banks and their financial system. The Central
Bank of Kuwait is devoted on providing an incorporated framework of supervisory and
regulatory rules that organize banking activity. It is the responsibility of the CBK and the
Banking sector, to supervise the financial system in the State of Kuwait and directing its credit
policy, sustain economic, social development and monitoring the economic parameters. For
example (GDP, GNI, Unemployment, and Inflation). CBK efforts in these areas reflect its
enthusiasm to keep a pace with domestic, regional and world developments by dealing with their
reflections on the monetary banking conditions in the State of Kuwait.
10

The supervisory and regulatory rules cover the requirements of capital adequacy, liquidity,
rationalization and organization of the credit policy. Policy which classified banks credit
facilities, provisions calculations, credit concentration, investment policy, internal control
systems, risk measurement, rules and regulations concerning the required experience in Banks
Board Members and Executive officers, and combating money laundering, suspicious operations
and the financing of terrorism. (Cole & Gunther, 1995).

Regulatory steps to develop and expand economic movement are likely supplying a solid base
for continued economic expansion. The expansion in private and government sector disburse the
macroeconomic environment by giving further improvement to promote economic growth. The
prime beneficiary from the strong economic growth is the financial and banking sector (Sims,
1992).

Banks in Kuwait are facing numerous challenges caused by globalization and open market,
which likely affecting the banks ability to grow and operate with more competitive environment.
Kuwait economy relies on oil as a major driving force. Oil represents 90 percent of its
commodities export earnings and 80 percent of budget revenue (www.cia.gov). Further more, the
public sector dominate the economic sphere in terms of ownership and management of most
activities. Even the performance of the private sector and non-oil related activities are linked to
government intervention in terms of subsidized loans, input prices, equity injections, bailouts,
and preferences in government procurements.

The strong expansion in the banking sector depends on projects in the gas and oil sector. The
aggregate balance sheet of local banks (commercial, Specialized and Islamic Banks reached KD
29.1 billion at the end of the fiscal year 2006/2007, against KD 23.39 billion of the end of the
fiscal year 2005/2006 (CBK, 2007). The extreme expansion on the trading sector was derived by
the rising demand and supply of raw material, consumable and consumer items. As more and
more growth projects in the real estate are become visible, the development of real estate area
takes place. strengthen assets of local banks grew by 24.9 percent Year over Year (YOY) to
reach KD27.0 billion at the end of 2006, mainly due to the credit facilities to residents growing
11
by 26.3 percent to KD14.9 billion. During the period 2003-2006, the strengthen assets of local
banks grew at a CAGR of 12.8 percent from KD18.8 billion in 2003 to KD27.0 billion in 2006
(CBK, 2007).

2.1.2: K uwait banking str uctur e
The banking system in Kuwait includes Commercial banks, specialized banks, and banks
according to the provisions of Islamic Sharia.

Commercial banks
National Bank of Kuwait (NBK)
Commercial Bank of Kuwait (CBK)
Gulf Bank (GUB)
Al-Ahli Bank of Kuwait (ABK)
The Bank of Kuwait & the Middle East (BKME)
Burgan Bank (BUB)
The Branch of the Bank of Bahrain & Kuwait
The Branch of the BNP Paribas Bank
The Branch of HSBC Middle East Bank
The Branch of the National Bank of Abu Dhabi
The Branch of Citibank of New York

Specialized banks
Industrial Bank of Kuwait

According to the provisions of Islamic Sharia
Kuwait Finance House (KFH)
Boubyan Bank (BOUB)
Kuwait International Bank (KIB)

12

Figure 2.1: Banking & Financial Structure
(Source: chartsandnumbers.com, 2008)

Figure 2.1 shows information on banks of Kuwait as of May 2008. Apart from the basic
structure that falls under the Central Bank of Kuwait, it provides information on Year of
establishment, and number of operating local bank branches in the State of Kuwait (excluding
head offices).

2.2: BANK R AT I NG SY ST E M

At the closing stage of twentieth century, banks suffered from reaching level which was not seen
since the enormous depression of the 1930 (Altman, 1993). The earliest researches on this issue
went back to the well-known US banking sector crises on 1920-1930 as the author had answered,
what ratio effect failed banking? (ALTMAN, 1968). Researchers used indicator-based (financial
ratio) approach to predict banking failure (Hardu & Virag, 1990),
13
(Sinky, 1975) was the preliminary examiner who used the discriminant analysis to measure the
banks performance and banking failure. He also used ratios that related to liquidity, asset quality,
profitability and capital adequacy. Early warning model research was devoted in the 1970 and
1980s by founding the important predicators indicators of bank problem: profitability, capital,
assets quality, and liquidity appeared as statistically significant in almost every study, even
though they were often measured using different ratios. Putnams (1983)

Federal regulators in USA developed CAMEL rating system in the early 1970s, to structure the
bank examination process. In 1979, the Uniform Financial Institutions Rating System was
adopted to provide federal bank regulatory agencies with a framework for rating financial
condition and performance of individual banks (Siems & Barr, 1998). The convention of
CAMEL factors assess in measuring banks financial strength by regulators who became
common since 1979. (Piyu, 1992). Presently, financial ratios are used to evaluate the overall
financial banks soundness and quality of management. Bank regulators, for example, use
financial ratios to help evaluate banks performance as part of the CAMEL system. The factors
of the evaluation are as follows;
(C = Capital adequacy, A = Asset quality, M = Management quality, E= Earnings ability, L =
Liquidity).

Federal regulators used the CAEML rating as an early warning system to examine and spot on
the problems of banks which face the bankruptcy risk. CAMEL is considered to be a bank rating
system which used in finding out the Capital adequacy, Asset quality, Management quality,
Earnings, and Liquidity. A scale of 1-5, with 1 being the strongest rating, the bank examiners
scores banks in each CAMEL category. The underlying factor scores forms the basis of overall
CAMEL rating. The examiners can find sufficient information from bank balance sheet and
income statements to assess capital adequacy, asset quality, earnings ability, and liquidity. The
management quality is the most complex part in evaluating the CAMEL rating factors (Barr &
Siems, 1992).

In 1996, sixth factor relating to Sensitivity to market risk was added to the CAMEL rating,
making it CAMELS. (Cole & Gunther, 1998)
14

However, the Central bank of Kuwait has used the CAMEL rating, and has neglect the
sensitivity to market risk as per the CBK circular dated 16/10/2005 to local banks in Kuwait
concerning an updating of CAMEL rating methodology of banking performance (CBK, 2006) .
Hence, the lack of data for the sensitivity to market risks measure in the case of Kuwait

In order to appraise management quality of banks, a model is developed to predict the bank
failures. This model emphasis on banks intermediate functions of acquiring deposits, making
loans, investments and also view bank as a processing multiple units to produce multiple outputs
by using data envelopment analysis (DEA). After considering a number of different variables to
capture each of the component parts of the CAMEL rating scheme, they settle on equity capital
to total loans (Capital Adequacy), non-performing loans to total assets (Asset Quality). By using
the CAEL method Management will be analyze upon the CAEL factor, net income to total assets
(Earnings), and large deposits to total assets (Liquidity) (Cole & Gunther, 1998)

The discriminant analysis (DA) (was a traditional techniques used for differentiating group
category depending on variable). Factor analysis, proportional hazard models, and logic analysis
have also been used to study the CAMEL rating. The studies use variables that reflect Asset
quality, Liquidity, Capital adequacy, Management quality, and local or regional economic
conditions (Cole & Gunther, 1998). The composite rating ranges between 1 (best) and 5 (worst),
and also involves a certain amount of subjectivity based on the examiners overall assessment of
the institution in view of the individual component assessments (Cole & Gunther, 1998).

15
Table 2.1: CAMEL Rating system and description
CAMEL
composite
rating
Description
1
Financial institutions with a composite 1 rating are sound in every respect and generally have
individual component ratings of 1 or 2.
2
Financial institutions with a composite 2 rating are fundamentally sound. In general, a 2-rated
institution will have no individual component ratings weaker than 3.
3
Financial institutions with a composite 3 rating exhibit some degree of supervisory concern in
one or more of the component areas.
4
Financial institutions with a composite 4 rating generally exhibit unsafe and unsound practices or
conditions. They have serious financial or managerial deficiencies that result in unsatisfactory
performance.
5
Financial institutions with a composite 5 rating generally exhibit extremely unsafe and unsound
practices or conditions. Institutions in this group pose a significant risk the deposit insurance
fund and their failure is highly probable.
(Source: Wirnkar & Tanko, 2008)

Most studies find that Capital adequacy, Earning ability, and Asset quality, measured by the
concentration of certain loan types, On the other hand, Heyliger & Holdren (1991) discover that
Asset quality, measured by the ratios of loan loss provisions and net charge offs to total loans, do
not provide reliable indicators of bank failure. The subjective factors also should be considered
by the examiners to find out the Management quality rating.

2.3: CAME L S COMPONE NT S
The various components of CAMEL rating can be defined as follows (Aktas et al, 2005)

Capital adequacy
Size of the bank
Volume of inferior quality assets
Banks growth experience, plans and prospects
Quality of capital
Retained earnings
16
Access to capital markets
Non-ledger assets and sound values not shown on books (real property at nominal values,
charge-offs with firm recovery values, tax adjustments)

Asset quality
Volume of classifications
Special mention loans ratios and trends
Level, trend and comparison of non-accrual and renegotiated loans
Volume of concentrations
Volume and character of insider transactions

Management factors
Technical competence, leadership etc of middle and senior management
Compliance with banking laws and regulations
Adequacy and compliance with internal policies
Tendencies towards self-dealing
Ability to plan and respond to changing circumstances
Demonstrated willingness to serve the legitimate credit needs of the community
Adequacy of directors

Earnings
Return on assets compared to peer group averages and banks own trends
Material components and income and expenses compare to peers and banks own
trends
Adequacy of provisions for loan losses
Quality of earnings
Dividend payout ratio in relation to the adequacy of bank capital

Liquidity
17
Adequacy of liquidity sources compared to present and future needs
Availability of assets readily convertible to cash without undue loss
Access to money markets
Level of diversification of funding sources (on- and off-balance sheet)
Degree of reliance on short-term volatile sources of funds
Trend and stability of deposits
Ability to securities and sell certain pools of assets
Management competence to identify, measure, monitor and control liquidity position

For analyzing and identifying the rating of banks, various systems are used. These systems are
selected under four extensive categories.

1. Supervisory bank rating systems;
2. Financial ratio and peer group analysis systems;
3. Comprehensive bank risk assessment systems;
4. Statistical models.

One of the main rating methods used widely to analyze the rating of the banks is the Supervisory
bank rating system. Banks supervisors use on-site and off-site examination or surveillance in the
purpose of identifying banks which are on loss. As On-site includes the valuation of various
banks and its review of all aspects, safety and soundness examination, it is considered to be the
most useful tool for identifying problems in a banking sector. Even though on-site is most
valuable method; however, it cannot be used always because of its high cost, labor intensive
nature and burdensome to bankers by disturbing their day by day operations. Banks off-site
monitoring are done by the supervisors to avoid the inconveniences of banking function (Barker
& Holdsworth, 1993).The off-site surveillance provides supervisors an accurate picture of bank
condition, thus enabling them to plan exams and schedule effectively. The banks are provided by
the off-site surveillance in order to maintain the soundness and safety between on-site visits.

The main contribution of an analyst towards banking system has been the estimation and
simulation of econometric models designed to provide supervisors with early warning of the
18
banks that are most likely to develop serious problems in the future. According to Gilbert,
Meyer & Vaughan (1999) econometric models use the information about the condition of banks
in their financial statements to derive one number. The derived number is used by most of the
early warning models as the probability under which a bank will fail in a future period.

Table 2.2: Supervisory Risk Assessments and early waning Model
Country
Supervisory
Author
System Type
France Banking
Commission
ORAP
(Organization and Reinforcements
Of Preventive Action)
Off-Site
Supervisory bank Rating System
SAAP
(support System for Banking
Analysis)
Early Warning model- Expected
losses
Germany German Federal
Supervisory
Office
BAKIS (BAKred Information
System)
Financial ratio and peer group
analysis system
Italy Bank of Italy PATROL Off-Site
Supervisory bank Rating System
Netherland Netherland Bank RAST Risk Analysis Support Tools
- Observation system
Comprehensive bank risk
assessment system
United
Kingdom
Financial
Service
Authority
RATE (Risk assessment, Tools of
Supervision and Evaluation)
Financial ratio and peer group
analysis system
Bank of England TRAM (Trigger Ratio Adjustments
and Evaluation)
Early Warning model
United
States
All Three
Supervisory
Authorities
CAMELS On site examination process
Federal Reserve
System
Individual Bank Monitoring Screen Financial Ratio analysis
SEER Rating (System For
Estimating Exam Rating)
Early warning system
SEER Risk Rating Early warning system
FDIC CAEL Supervisory Bank Rating
System
GMS- Growth Mentoring System Early warning system
SCOR
(CAMELS Off Site Rating)
Early warning system
OCC Bank Calculator Early warning system
Source: Gilbert et al, (1999)
19

The above table illustrates the tools approach used by supervisory risk assessments and early
warning system that have been developed recently and are currently in use or being developed in
number of G10 countries. Many supervisory agencies implemented one or more system for risk
assessments and early warning during the 1990s. While some of the systems are able to provide
post indication of existing problem, other systems try to generate ante warning of potential
problem that may emerge or develop on accounts of current risk profile of the banking
institution. Overall, supervisory risk assessments and early warning system assist in:
Systematic assessment of banking institution within a formalized framework both at the
time of on-site examination and in between examinations through off-site monitoring.
Identification of the institution and areas within institution whereas problem exist or are
likely to emerge.
Prioritization of banks examinations of optimal allocation of supervisory resources and
pre-examination planning.
Initiating prompt action by the supervisor.

The assessment derived on the basis of on-site examination in an organization initiates the
supervisory rating of banks. Over the last few years, the approach has also been developed and
applied to function on an off-site basis. The institutions whose conditions deserve an immediate
supervisory attention in both mandated and non-mandated authorities are identified with the help
of supervisory bank rating system (Thomson, 1991).

The subjective assessments are the basis of on-site examination ratings, by which the examiner
identifies the various aspects of the functioning of banking institution. Even though these
assessments are not much demanding and restrictive, they form the benchmarks for the rating of
banks, which allows the examiner to consider other factors that may be important for his
assessment. The on-site examination ratings are only shared with the management and not with
the public.

The off-site analysis of regulatory and other information available to the supervisor and the
information obtained from onsite examination report forms the basis of Off-site supervisory
20
ratings. These ratings are assigned on the basis of a continuous process of evaluation of a
banking institution over a period of time, generally one year. The supervisors generally use the
off-site supervisory bank ratings which are normally confidential.

For identifying the existing problems and to assess the financial condition of a banking
institution, on-site examination ratings are used as important tool. Onsite examination provide
reference point for the financial condition of a banking institution but as the problems obtained
in the banking institution are ex post, these ratings and their assessments may be relevant only
for short period of time (Wheelock & Wilson, 2000).

The changes that occur in the financial conditions are not tracked by the on-site examination
ratings, and may start decreasing after examination process completes. This is more pronounced
in the case of banks already in financial trouble, as well as in periods of banking industry stress.
Various studies have shown that while on-site examination ratings have the advantage of
incorporating confidential supervisory information along with regulatory and publicly available
information, the value of this information content may begin to decay two quarters after the
examination process is complete. (Looney et al, 1989).

The ratings available by the on-site examination are relatively old. It means, if the banks are
examined once in a year, the ratings available at one time are generally six months old. This is,
in fact, the beginning of the period over which the usefulness of the information of on-site
examination rating begins to decline (Looney et al, 1989).

On-site examination ratings like CAMEL are useful in the analysis of the financial condition of
the bank at the time of the examination, its conformity with regulatory policies, the accuracy of
the regulatory reporting, the quality of its management, the loan loss recognition, and the internal
controls practiced, as well as in detecting financial misconduct. If banks are examined at frequent
intervals and their financial conditions remain stable, ratings like CAMEL can be accurate
indicators of potential problems. Supervisory on-site examination ratings cannot be expected to
function as condition indicators of banks for long periods of time, much less to serve as early
indicators of future problems (Gilbert et al, 1999)
21

Off-site supervisory ratings that are based mainly on information available through regulatory
reporting can, by comparison, track the changes in the financial condition of banks, as the off-
site information flow is more frequent than actual on-site field examinations. The ongoing
supervision requires off- site monitoring as the minimum tool for analysis. The off-site
monitoring is mainly used by those authorities, who do not have enough resources to carryout
periodic onsite examinations, and they rely on this method to monitor the financial condition and
performance of banks and to identify the institutions that need special attention (Barker &
Holdsworth, 1993). The process involves analyzing and reviewing periodic financial and other
information received by the supervisor relating to banks activities. Supervisors typically subject
regulated banks to reporting requirements covering, for instance, balance sheet and profit and
loss statements, business profile, loans, investments, liabilities, capital and liquidity levels, loan
loss provisions, etc.

An early-warning system cannot replace the on-site examination, which allows for personal
interaction with the bank's management and employees and permits first-hand evaluation of
operating procedures, levels of risk-taking, and long-range strategic planning. By identifying the
institutions that need early examination or possible interventions, an effective warning system
can complement the on-site examination process. For an early-warning or a failure-prediction
model to be useful to regulators it must have the following ingredients:

Understandability-For the model to be accepted and used by the examination staff, it must be
understandable and their intuitive perceptions of how banks fail; the model will not be trusted if
it is considered a \black box" where banks are rated according to some highly complex process.

Ease of use/quickness-To yields the greatest benefits; an early-warning system's data must be
timely and accurate. Fortunately, banks are already required to submit quarterly balance sheet
and income statement information to banking regulators, and models built around this database
can rely on up-to-date, reliable inputs.

22
2.3.1: Management s R ole
The quality of a bank's management is a key to its long-run survival, and one of management's
greatest challenges is coping with the industry's increasing uncertainties and accompanying risks
.The internal meaning of these will be the effective allocation of scarce resource, implementation
of procedures and controls to minimize control costs and risks and becoming open to the use of
new technologies to increase the operating efficiencies .The banks management should
externally keep speed with new economic fluctuations, technological advances, regulatory
actions, societal trends and changes taking place in the global economy.

2.3.2: Pr ofitability analysis
The profitability analysis is the most common tool used for financial performance .This analysis
is used to assess the managements investment in firms as total capitals and for raising funds.
The profitability is most important to the firms total shareholders. In adverse conditions such as
losses on loans or losses cost by unexpected changes in interest rates profits serves as a guard.
The creditors and regulators are also concerned about profits which will protect their interest
from failure. Profits depend on three primary structural aspects of financial institutions: Financial
leverage, Net interest margin and non-portfolio income sources. Return on Equity, (ROE) and
Return on Assets (ROA) are the most commonly applied profitability ratios used to assess
financial performance (Looney & Wansley, 1989).

2.3.3: Capital adequacy r atios
Capital adequacy ratios relate to the firms overall use of financial leverage.
More volatile earnings behavior is mostly experienced by the organizations with high financial
control. It indicates the extent to which an institution's capital base covers the risks inherent in its
operations. The major capital adequacy ratios include:

1. Shareholders equity to Total assets
2. Shareholders equity to Total loans
3. Shareholders equity to Total customer deposits (Gearing ratio).

23
2.3.4: L ong ter m solvency
The capability of an enterprise to survive over a long period of time is referred as solvency. It is
the same concept as liquidity except that it is for long term rather than short term. Ratios to
assess long-term solvency are measures of company riskiness. Theoretically no absolute has
been put forward as the best measure of a good level of solvency. Total liabilities to Total assets
and Shareholders' funds to Total Assets have been used in this study.

2.3.5: E ar nings and pr ofit per for mance emphasis
The banking sector management have shifted their focus to profitability because of the recent
developments in the sector which include: the need for additional capital adequacy funds
implying profits should be boosted as a main source, increased needs for provisioning of bad and
doubtful debts, need for funds for expansion and modernization or technological advancement to
serve customers better and attain competitive advantage (Whalen, 1991). This requires
consideration of efficiency and intensive capital investment, high volatility of interest rates and
exchange rates and intensive competition following liberalization of the sector. Weston &
Copeland (2000) concluded that profitability ratios are the most critical factors in a firms ability
to avoid failure.

2.4: CASE ST UDY
Supervisory disclosure of criteria and methodologies used in the review and evaluation
process of banks

The National Bank of Slovakia (NBS), in accordance with Section 6(16) (c) of Act no. 483/2001,
published the general evaluation criteria and the methodology which was in place towards
exercising of supervision over banks and its branches of foreign banks. Using article 144 of
Directive 2006/48/EC, obligation to disclose this information was laid down by the European
Parliament. This related to taking up and pursuing of the business of credit institutions.

The Committee of European Banking Supervisors (CEBS) agreed towards a common
supervisory disclosure framework in order to enable and compare disclosures of different
24
Member States. The content and structure of the disclosures were set out in the "CEBS
Guidelines on Supervisory Disclosure."

Supervisory disclosure is divided into four parts:
Application scope towards the Supervisory Review and Evaluation Process
Risk assessment Framework of individual banks
Internal Capital Adequacy Assessment Processes evaluation
Supervisory measures

Scope of the application of the Supervisory Review and Evaluation Process (SREP)
The Supervisory Review and Evaluation Process undertook the evaluating the bank's risk profile,
organization and management system in addition to its internal control and governance system.
Further measure included assessing and evaluating the adequacy of internal capital of the bank's
Internal Capital Adequacy Assessment Process.

Application of the Supervisory Review and Evaluation Process
Banks supervised by NBS, whether on an individual or consolidated basis, are included within
the Supervisory Review and Evaluation Process. With regards to a bank with its parent company
having its registered office is in another Member State, the only part of the consolidated unit that
will be included in the SREP is the bank incorporated in Slovakia and its subsidiaries. Foreign
bank branches come under supervision within the scope of the competences of the host Member
State, as laid down in Section 16 of Act no. 483/2001.

Application of the proportionality principle
National Bank of Slovakia SREP implementation applied the proportionality principle, with the
following three basic criteria:
Size of the bank;
Scale and complexity of its activities;
The bank's importance to financial sector stability.

25
2.4.1: CAME L S r ating
The CAMELS rating covers the capital, assets, management, earnings, liquidity and sensitivity
of the bank. Each of the assessed area is assigned a final numeric evaluation from 1 to 5. These
indicators are assigned to intervals of the evaluation values with a rating of 1 to 5, and each is
assigned a weighting. Management quality is evaluated on the basis of on-site supervision. In
other words if an on-site inspection has not been performed, information from off-site will be
used for assessment the assessment will use information from off-site supervision and from
meetings with the bank's management.

Finally rating is calculated based on the average ratings for each assessed area. This is then
rounded to a whole number. It is also based on the principle that the final rating is not one grade
higher than the area with the poorest assessment. A quarterly rating is conducted and excludes
the management element (off-site rating). A comprehensive CAMEL rating is usually carried out
annually and is based on the conclusions from on-site supervision and off-site supervision which
includes numeric indicators.

2.5 L I T E R AT UR E GAP
The literature focused on discussing the CAMELS rating system and bank performances
pertaining to through various international studies and articles. This is a common tool being
used with the banks in Europe and Western countries and is relatively new in Kuwait. The
literature provided information regarding the use of this tool restricted to conventional banks,
where this research performed a discriminant analysis to compare the performance of
conventional and Islamic banks in Kuwait. This kind of study is new especially to this region
and therefore this is being taken as the major literature gap.

Further data that have collected in the study is from a published report of IBS Kuwait, whereas
most of the studies in the literature discussed their findings based on data collected directly from
the banks. This is another gap in this study.

26
2.6 SUMMAR Y
In this literature, the author gives an overall idea about the evaluation of banks performance in
Kuwait with the help of CAMEL ratios. Study focused on both conventional and Islamic banking
system to assess the rating and performance. The CAMEL rating system is used for finding out
the ratios like Capital Adequacy, Asset Quality, management Quality, Earnings and liquidity.
With the help of supervisory analysis the data can be analyzed to calculate the efficiency of
banks performance.

27

CHAPT E R 3: ME T HODOL OGY

This chapter focuses on the details of the study undertaken to address the questions posed in
Chapter One. It describes the processes of setting up the study conducted on the basis of banks
rating system, selecting the literature review, the data collection process including the tools and
methodologies used and finally, data analysis and conclusion. This research was designed to
generate discriminant data based on the CAMEL rating system of banks

3.2: PR OBL E M ST AT E ME NT
The increase of global demands of Islamic finance leads few local conventional banks to
diversify to Islamic banks to increase bank revenue by targeting those Non interest bank clients
(NIB) and to meet customer perception. For example on December 25, 2006, the shareholders of
KREB (Kuwait Real Estate Bank) amended the Articles of Association to change the name of
the bank. Subsequently, in June 2007, the bank received approval from the Central Bank of
Kuwait (CBK) to operate as an Islamic bank with effect from July 1, 2007 (TAIB, 2008).
Moreover, Bank of Kuwait and Middle East is in process of diversification into Islamic banking
after receiving necessary approval from the Central Bank of Kuwait (CBK) dated June, 2008
(ARAB Time, 2008). These changes call for understanding of the relative performance of
Islamic banking and commercial banking. Specifically, is Islamic banking more profitable than
conventional banking? The issue is of interest to stakeholders in view of the current global
financial crises. Investors will like to know in order to inform their investments decisions. The
depositors will like to know in order to have reasonable assurance of the safety for their deposits.
If indeed there is performance deference in profitability between Islamic and conventional banks,
it is useful to know what factors are influencing this difference.

28
3.3: R E SE AR CH OBJ E CT I VE S
The main objective of this study is to find factors discriminating the Islamic banks from
conventional banks and to indicate the relative impact of each factor.

3.4: R E SE AR CH QUE ST I ON

1. What factors discriminate between Islamic banks and conventional bank performance?
2. Which of those factors is more important in discriminating between the two banks
categories?
3.5: R E SE AR CH ME T HODS
The research followed a quantitative approach. Data was not collected directly from the
respondents, instead published reports from IBS Kuwait was utilized. Data from year 1999 to
2007 was taken from these reports. This followed the secondary data approach.

3.5.1: Secondar y data
In addition to the methods and types discussed above, data collected in this study refer to
secondary data. Data collected here is through industry report of the Institute of Banking
Studies, Kuwait.

3.6: DAT A ANAL Y SI S T Y PE S AND ME T HODS
Discriminant function analysis is a statistical technique used to determine which variables
discriminate between two (or more) naturally existing groups. Specifically, the question is
whether or not two (or more) groups are significantly different from each other with respect to
the mean of a given variable(s). If the earnings for a variable are extensively different in different
groups, then this variable discriminates between the groups.

The most common application of discriminant function analysis is to include many measures in
order to determine the ones that discriminate between groups. This leads to building a model of
29
how best to predict to which group a given variable belongs. A model can be built step by step,
where all variables are reviewed and evaluated at each step to determine which contribute the
most to discriminating between groups. It can also be done backwards, where all variables are
included in the model and at each step, the variable that contributes the least to the predictive
model is eliminated.

Outputs such as Wilks Lambda, Eigenvalue, Standarized Canonical Discriminant Function
Coefficient, Structure Matrix, and Test of equity of group mean and Classification result were
extracted and discussed in the data analysis chapter. The SPSS statistics software package is
used for analyzing the data. The Kruskal-Wallis test was used to examine whether the medians
are equal across groups (Green et al., 2000). This test is equivalent to a one-way ANOVA test
(Coakes & Steed, 2001; Puri, 1996). The Kruskal-Wallis test was used to examine the rating
between the banks in Kuwait.

3.7: SAMPL E COL L E CT I ON AND DAT A ANAL Y SI S
In this chapter the researcher outlined the research approach, including collection of data for
quantitative analysis. This approach was used to generate new knowledge, new hypotheses, or
support for existing theories. The secondary analysis enabled access to live data and the
perspectives of specialists in the banking field of Kuwait.

30
Table 3.2: Data taken from the secondary data
C [Capital Adequacy]

Share Capital / Loans
Share Capital / Equity
A [Asset Quality] Non-performing loans / Loans
M [Management Quality] Will be commented based on the results of other factors
E [Earnings] Operating Expenses / Total Assets
L [Liquidity] Total Loans / Total Assets
S [Sensitivity] Interest Sensitive Assets / Interest Sensitive Liabilities
(Source: IBS Annual Report, 2007)

3.8: SUMMAR Y
In this study also the researcher collected the secondary data for quantitative analysis. This
approach can be used to generate new knowledge, new hypotheses, or support for existing
theories; that it reduces the burden placed on respondents by negating the need to recruit further
subjects; and that it allows wider use of data from rare or inaccessible respondents. In addition, it
has been suggested that secondary analysis is a more convenient approach for this research. In
this study the Financial operating report as secondary data, and which collected from the institute
of banking studies Kuwait.

31

CHAPT E R 4: DAT A ANAL Y SI S AND DI SCUSSI ONS

This chapter discusses the empirical data analysis and findings collected from the IBS research.
The data pertaining to 1999 till 2007 was used for the discriminant analysis using SPSS.
Stability of the financial institutions depends on the safety and soundness of individual banks.
Therefore, is it essential for the banks to have analytical systems to monitor and forecast its
financial condition. With this regard the CAMELS rating system was created and used in the
Western and European banks. In 2005 the Central Bank of Kuwait issued a circular stating the
update and usage of CAMELS rating system as an Early Warning system for the Kuwait Banks
(CBK, 2006).

This study is based on the discriminant function analysis which is used to classify cases into
various categorical dependent. Discriminant analysis is a tool that enables finding out the
differences between specified groups. Here, discriminant analysis helps towards understanding
the financial segments ability and differences between the conventional and Islamic banks of
Kuwait. The five factors of CAMEL (capital adequacy, assets, management quality, earnings
and liquidity) are the ratios taken for the study. The capital adequacy has been split into 3 ratios
to achieve and clearer and accurate analysis. Sensitivity (S) ratio has been avoided due to lack of
adequate data provided by the IBS research.

The conventional banks include Al Ahli Bank of Kuwait, Bank of Kuwait and Middle East,
Burgan Bank, Commercial Bank of Kuwait, Gulf Bank, National Bank of Kuwait, Kuwait Real
Estate Bank and the Industrial Bank of Kuwait. The Islamic banks consist of the Kuwait Finance
House and the Boubyan Bank. The Boubyan Bank has been established since 2004 and the data
available pertains only to 2005 and 2006.

32

The IBS report is grouped into liquidity measures, structural measures, profitability measures
and other measures. The liquidity measures contain information such as liquid asset which are
expressed as a percentage of total assets and deposit liability separately. Structural measures are
used to analyze the asset / liability structure of the bank. It will also provide the information
about the sources and application of funds. The probability measures analyze the profitability.
Other measures indicate the efficiency of the productivity of the bank. It is also related to the
equity share and stock market performance of the bank.

The analysis is based on the following hypothesis testing:
H
0
= There is a significant difference between Conventional and Islamic banks of Kuwait
H
1
= Capital Adequacy has significant impact on the discriminant value between conventional
and Islamic banks
H
2
= Asset Quality has significant impact on the discriminant value between conventional and
Islamic banks
H
3
= Management Quality has significant impact on the discriminant value between conventional
and Islamic banks
H
4
= Earnings has significant impact on the discriminant value between conventional and Islamic
banks
H
5
= Liquidity has significant impact on the discriminant value between conventional and
Islamic banks

4.2: DE SCR I PT I VE ANAL Y SI S
The descriptive analysis is used to determine the specific element that are present and provide
reliable measurements of sample data. The value N has an important role to monitor the data,
if the N differs greatly; the output the author expected will be varied. Consider this an early
warning of problems that may arise when the variables are examined together later on. You
would then want to track down why cases are being lost between variables. At the same time, out
of range values with unexpectedly high (or low) means and standard deviations, and other simple
parameters,

33
Table 4.1: Descriptive Analysis
N Minimum Maximum Sum Mean Std. Deviation
Capital Adequacy -
Calculation 2
83 .027 .360 9.129 .10999 .066526
Asset Quality
83 .000 1.179 8.862 .10677 .153122
Management Quality
83 .005 .065 2.668 .03214 .013833
Earnings
82 .002 .046 1.103 .01345 .008079
Liquidity
83 .125 .845 43.086 .51911 .141758
Valid N (listwise)
81
(Ahmed, 2008)

4.3: DI SCR I MI NANT ANAL Y SI S
This section provides the various data analysis and findings through the discriminant analysis.
Each of the table provided below will be discussed and explained. With regards to generating
the discriminant analysis, the stepwise method was used. In doing so, it was possible was
possible to select the Mahalanobis distance test and canonical discriminant function with relevant
independent variables.

Table 4.2: Case processing summary
Unweighted Cases N Percent
Valid 82 98.8
Excluded Missing or out-of-range
group codes
0 .0
At least one missing
discriminating variable
1 1.2
Both missing or out-of-
range group codes and at
least one missing
discriminating variable
0 .0
Total 1 1.2
Total 83 100.0
(Ahmed, 2008)

34
Table 4.2 is the total case processing summary for the discriminant analysis. One case have been
displayed has having missing values. The missing data are towards the 2007 Earnings of Kuwait
Finance House.

4.3.1: E quality of Gr oup Means
Wilks Lambda is the significance test used in the discriminant function. From the following
table (4.2), the Wilks Lambda value is compared with the significance value to determine the
validity of the functions.

Table 4.3: Tests of Equality of Group Means

Wilks'
Lambda
F df1 df2 Sig.
Capital Adequacy -
Calculation 2
.984 1.337 1 80 .251
Asset Quality .984 1.336 1 80 .251
Management Quality .976 1.981 1 80 .163
Earnings .723 30.723 1 80 .000
Liquidity .645 44.109 1 80 .000
(Ahmed,2008)

According to table 4.3, the last two independent variables qualify, as they fall within the
expected significance value of 0.05. The Wilks Lambda value of 1 indicates no group
difference therefore smaller the values of Wilks Lambda greater the higher the importance of
the independent variable. Based on this explanation it can be observed from the table Earnings
with a value of .716 and Liquidity with value of .641. These also have a significance value
below to .05 suggesting that they qualify compared to other independent values in the table.

4.3.2: Cor r elation
The following table (4.3) show the correlation between each of the independent variables.
Correlation represents nature and size between two variables (Cramer, 2003). Correlation index
varies from -1 to 1. In this study we examined the correlation between the five independent
variables. According to Tabachnick and Fidell (2001), the coefficient values greater than .30 are
considered meaningful.
35

Table 4.4: Pooled within-groups matrices / correlation

Capital
Adequacy -
Calculation 2 Asset Quality
Management
Quality Earnings Liquidity
Correlation Capital Adequacy -
Calculation 2
1.000 .353 .121 .086 -.214
Asset Quality .353 1.000 .215 .067 .104
Management Quality .121 .215 1.000 .089 .148
Earnings .086 .067 .089 1.000 .102
Liquidity -.214 .104 .148 .102 1.000
(Ahmed, 2008)

Based on table 4.4, the expected values higher than .30 are highlighted. The findings revealed
the following to be positively correlated with each other:
Capital Adequacy 2 with Asset Quality
Asset Quality with Capital Adequacy 2
By taking correlation between the ratios, asset quality has an effective value with 0.353

4.4: CANONI CAL DI SCR I MI NANT FUNCT I ONS
The canonical discriminant function consists of Eigenvalues, Wilks Lambda and function of
Group Centroids relevant to this study.

Table 4.5: Eigenvalue
Function Eigenvalue % of Variance Cumulative %
Canonical
Correlation
1 .948(a) 100.0 100.0 .698
First canonical discriminant functions were used in the analysis.
(Ahmed, 2008)

Canonical correlation analysis (CCA) was developed by H. Hotelling (1936) and is used mainly
in economics, medical studies and is known as learning and signal processing. CCA is used for
36
measuring the linear relationship between two multidimensional variables (Borgas, 2001). CCA
find two bases in which the correlation matrix between the variables is diagonal. Therefore the
correlations on the diagonal are maximized. CCA can be defined as the problem of finding two
sets of basis vectors; x and y. The Cannonical correlation suggests that significant amount of
variances are explained by the model. This finding is more pronounced in the Wilks Lambda
test (See Table 4.5).

Table 4.6: Wilks Lambda
Test of Function(s)
Wilks'
Lambda
Chi-square df Sig.
1 .513 52.360 3 .000
(Ahmed, 2008)

The accepted value of Wilks Lambda is .30 and the significant level should be .005 with a
probability value of p < .001. According to table 4.x, the Wilks Lambda value is .513 and
significant value is .000 which indicated that there is a significant evaluation of the two groups.
Therefore it proves hypothesis H
0
(There is a significant difference between Conventional and
Islamic banks of Kuwait).

Table 4.7: Functions at Group Centroids
Bank Category
Function
1
Conventional Banks -.488
Islamic Banks 3.462
Unstandardized canonical discriminant functions evaluated at group means
(Ahmed, 2008)

The functions at group centroids (See Table 4.7) refer to the average discriminant score for
variables in two groups. To interpret the relationship between the conventional and Islamic
banks, it should initially identify the discriminant function between each group. In this case
conventional banks have a value of -.488 and Islamic banks have a value of 3.462. The score
calculation of the function should be zero and this can be checked by calculating the sum of
37
means multiplied by the number of cases in each group. Conventional bank 71 cases x -.488 = -
35 and Islamic bank has 10 cases x 3.462 = 35 which equals to zero. Hence, it can be derived
that H
0
is true (There is a significant difference between Conventional and Islamic banks of
Kuwait).

Discriminant functions are explained by means of standardized coefficients and the structure
matrix. Standardized beta coefficients are given for each variable in each discriminant
(canonical) function (See Table 4.8), and the larger the standardized coefficient, the greater is the
contribution of the respective variable to the discrimination between groups. However, these
coefficients do not tell us between which of the groups the respective functions discriminate. We
can identify the nature of the discrimination for each discriminant function by looking at the
means for the functions across groups

Table 4.8 Standardized Canonical Discriminant Function Coefficients

Function
1
Management Quality -.325
Earnings .589
Liquidity .751
(Ahmed, 2008)

The standardized discriminant function coefficients in the table above serve the same purpose as
beta weights in multiple regressions: they indicate the relative importance of the independent
variables in predicting the dependent. A discriminant function is a weighted linear combination
of the predictor variables, with the weights chosen such that the criterion groups differ as much
as possible on the resulting discriminant function.

The structure matrix coefficient (See table 4.9) indicates the correlation between each predictor
variable and the discriminant function.

38
Table 4.9: Structure Matrix

Function
1
Liquidity
.762
Earnings
.636
Management Quality -.162
Capital Adequacy -
Calculation 2(a)
-.149
Asset Quality(a) .048
(Ahmed, 2008)
- Pooled within-groups correlations between discriminating variables and standardized canonical
discriminant functions
- Variables ordered by absolute size of correlation within function.

For the discriminant function, it can be seen that the correlation coefficients have high values for
the first three variables, which means that these variables are most strongly correlated with the
function. Therefore, Liquidity and Earnings are the most important variables in explaining the
difference between Islamic banks and conventional banks.

Table 4.10: Classification Results

Bank Category
Predicted Group Membership
Total

Conventional
Banks
Islamic Banks
Original Count Conventional Banks 70 2 72
Islamic Banks 5 6 11
% Conventional Banks 97.2 2.8 100.0
Islamic Banks 45.5 54.5 100.0
Cross-
validated(a)
Count Conventional Banks
69 3 72
Islamic Banks 5 6 11
% Conventional Banks 95.8 4.2 100.0
Islamic Banks 45.5 54.5 100.0
(Ahmed, 2008)

a) Cross validation is done only for those cases in the analysis. In cross validation, each case is classified by
the functions derived from all cases other than that case.
b) 91.6% of original grouped cases correctly classified.
39
c) 90.4% of cross-validated grouped cases correctly classified.

Classification result (See table 4.10) is a simple summary of number and percent of subjects
classified correctly and incorrectly. The leave-1-out classification is a cross validation method
of which the results are also presented (cs.uu.nl 2008).The table above is used to assess how well
the discriminant function works, and if it works equally well for each group of the dependent
variable. It correctly classifies about 92% of the cases, but this is not as good as it seems.
Discriminant analysis gets conventional banks correctly classified. However, it misclassifies
Islamic banks. The seemingly high 95.8% rating is obtained by classifying nearly every
conventional bank in a sample which is preponderantly conventional bank.
4.5: K R USK AL -WAL L I S T E ST
The Kruskal-Wallis test provides a ranking between groups compared to various independent
variables. In the case of our study the comparison is between conventional and Islamic banks
with independent factors such as Capital Adequacy, Asset Quality, Management Quality,
Earnings and Liquidity.
Table 4.11: Ranking
Bank Category N Mean Rank
Capital Adequacy -
Calculation 2
Conventional Banks 72 45.39
Islamic Banks 11 19.82
Total 83
Asset Quality Conventional Banks 72 43.14
Total 83
Management Quality Conventional Banks 72 42.97
Total 83
Earnings Conventional Banks 72 38.28
Total 82
Liquidity Conventional Banks 72 36.63
Total 83
(Ahmed, 2008)

40
According to table 4.11, the prime factor that contributes to such a wide difference in ranking is
the lack of capital values in the Islamic banks. Capital Adequacy Calculation 2 (Share Capital
/ Loans) shows that conventional banks are ranked higher by 45.39 compared to Islamic banks at
19.82. Here both the banks have all the values respect to the independent variables. Based on the
Capital Adequacy study we can conclude that conventional banks do better compared to the
Islamic banks.

This proves hypothesis H
1
(Capital Adequacy has significant impact on the discriminant value
between conventional and Islamic banks).

The second independent factor is Asset Quality which is Non-performing loans / Loans. In this
category conventional banks are ranked at 43.14 with Islamic banks at 34.55. Here too the
conventional banks are ranked higher. The third independent factor is Management Quality.
This has been calculated by Interest Expenses / Total Assets. In this category conventional
banks are ranked at 42.97 with Islamic banks at 34.55. The fourth independent factor is Earnings
(Operating Expenses / Total Assets). In these category conventional banks has only a ranking of
38.28 whereas Islamic banks have a higher rank of 64.65.

This proves the following hypothesis:
H
2
= Asset Quality has significant impact on the discriminant value between conventional and
Islamic banks
H
3
= Management Quality has significant impact on the discriminant value between conventional
and Islamic banks
H
4
banks

The final independent factor is Liquidity (Total Loans / Total Assets). Here the Islamic banks
are ranked higher with 77.18 and conventional banks by 36.63. This is the highest ranking in
Islamic banks. Liquidity refers to the ease the ease of a company to buy and sell financial
instruments for cash without causing any significant change in its price. A very actively traded
market, where it's easy to sell whatever you're holding for cash without discounting its price
41
heavily is said to be a liquid market. A market where it's difficult to sell whatever you're holding
for cash unless its price is discounted is said to be an illiquid market. Liquidity is prized because
it increases the 'efficiency' of a market - that is, its capacity to find the 'true price' of whatever is
being traded (financial-guide.net, 2008).

This proves the following hypothesis:
H
5
Islamic banks

Overall, it can be argued that Kruskal-Wallis test proves the hypothesis, H
0
(There is a
significant difference between Conventional and Islamic banks of Kuwait).

4.5.1: T est Statistics

Table 4.12: Test Statistics

Capital
Adequacy -
Calculation 2
Asset Quality
Management
Quality
Earnings Liquidity
Chi-Square 10.741 1.213 .872 10.905 27.015
Df 1 1 1 1 1
Asymp. Sig. .001 .271 .350 .001 .000
(Ahmed, 2008)
a) Kruskal Wallis Test
b) Grouping Variable: Bank Category

Based on table 4.9, Capital Adequacy 2, Earnings and Liquidity are below the significant
expected value of .05. This proves the following hypothesis:

H
1
= Capital Adequacy has significant impact on the discriminant value between conventional
and Islamic banks
42
H
4
banks
H
5
Islamic banks

4.6: SUMMAR Y
The discriminant analysis gives the possibility of calculating the standing of Conventional and
Islamic banks in Kuwait. Discriminant function analysis gives an understanding of the data set
produced by statistical values, as a careful examination of the prediction model that results from
the procedure helps into understand the relationship between groups (Conventional banks and
Islamic bank) and the variables used to predict group membership

Using the discriminant analysis the author has managed to identify those variables which have a
strong relationship in retaining the strength of banks. The selected variables significantly
contribute to the differentiation of the groups, namely: Capital Adequacy, Asset Quality,
Management, Earnings, and Liquidity. The discriminant score can better evaluate the standing of
the banks in Kuwait economy and Kruskal Wallis test to analyse the rating of banks.

43

CHAPT E R 5: CONCL USI ON, R E COMME NDAT I ONS AND FUT UR E
ST UDY

The chapter encompasses research based on the banks performance in Kuwait and their rankings.
The stability of any banking system depends mainly on the safety and soundness of individual
banks. Every bank has their own rating system in place for an effective monitoring the credibility
and financial condition of each institution. Risk assessment and risk detection method is used
widely in analyzing and valuating the bank, hence the supervisors do an effective assessing with
the help of potential artificial intelligence and expert human judgment. The early warning system
used in this study, CAMEL, is very effective to assess the banks. This model helps to predict the
banks stability, like to predict which bank will fail, and standing of their performance. Using
discriminant analysis, the secondary data related to banks in Kuwait are analyzed. The analysis
presented here in this study suggests that a banks choice of rating values can have a significant
effect on its performance and credibility requirements.

The result generated from this study helps in assessing the banks credibility. Using the values
generated through CAMEL the bank is evaluated. The secondary data collected for this study has
its inability to calculate some ratios. These financial ratios are often examined and analyzed
under groups reflecting different operating characteristics of banks. The popular categories
include capital adequacy, asset quality, management quality, earnings (or profitability), and
liquidity. These calculations gave more comprehensive understanding of bank performance,
changes in bank behavior, and the effect of specific policies or a menu of policies on the banking
sector.

44
5.2: CONCL USI ON
The research had two major questions which will be answered here factors that discriminate
between conventional and Islamic banks and which of these banks perform better. Each of these
two questions will be answered separately.

What factors discriminate between Islamic banks and conventional banks?
Banks determinants, classification and demands make supervisory authorities to pay greater
attention towards its performance. As evident from the literature and data analysis, Banks in
Kuwait use the CAMEL rating system as per CBK instruction provided in 2005.

Based on the discriminant data analysis outputs such test of equity of means, correlation,
canonical discriminant function, Wilks Lambda, Eigenvalue, function at group centroids and
standardized discriminant function coefficient the overall outcome showed that there was
discriminant between conventional and Islamic banks among the five factors of CAMEL. From
the Kruskal-Wallis test capital adequacy, earnings and liquidity fell within the accepted range of
0.05 thereby qualifying these for further analysis. The same output also provided the ranking for
each of the five factors. Liquidity was observed to have the highest ranking value (77.18) and
was in favor of the Islamic banks followed by the earnings at 64.65. The conventional banks
rated better on capital adequacy. The Islamic banking has strongest assets quality and credit
decision making against conventional banks which stand on percentage 34.55 against
conventional of 43.11 The management quality had more or less similar ranking between each
other, with 42.97 for conventional banks and 35.68 for Islamic banks.

Comparing between the p value of 0.05 and ranking, the accepted factors that can be taken for
the comparison between conventional banks and Islamic banks are capital adequacy, earning and
liquidity. From these it is evident that Islamic banks have stronger performance over
conventional banks. Liquidity was the main component that contributed towards this higher
performance within Islamic banks. Islamic banks are preferred within Kuwait due to its Sharia
rules and regulations that fit well within the Islamic traditions and values of the country and its
people.

45

Which of those factors is more important in discriminating between the two banks categories?
The most important factor that has discriminating the Islamic Banks from conventional is that,
the Liquidity, Earning and assets quality. Subsequent, liquidity and earning which have healthier
rating by 77.1 and 66.6 respectively, has demonstrate the global needs of Islamic instruments
specifically in Kuwait domestic market. Furthermore, the strongest rating of assets quality
percentage of Islamic banks pending from better credit decisions as impact of less loans
impairments.

5.3: ST UDY CONT R I BUT I ON T O CUR R E NT GL OBAL CR I SE S:
The international crises of U.S. mortgage left banks holding hundreds of billions of dollars of
nearly worthless credit instruments tied to home loans by a web of complex structures. The
global crises have given the chance for Islamic industry the opportunity to expand its appeal
beyond speculative excess.
While conventional banks worldwide are nursing losses of more than $400 billion from the credit
crisis, Islamic banks are virtually unscathed. And they are playing up the contrast to
shareholders, bondholders and borrowers.
Davied Testa Chief executive officer of Gatehouse Bank, which began operation in April as a
fifth Islamic bank in England, have said, The current global market condition has given Islamic
finance a great opportunity to show what it can do - help to fill the liquidity gap he said. The
competitive advantage that Islamic banking had in terms of products verities -despite the other
factors-, leads to great expansion of Islamic Banking and increase the global demands on the
Islamic instruments. (Umesh Desai, 2008)

46

5.4: R E COMME NDAT I ONS
Recommendations here are provided for both banks in Kuwait and IBS.

For the banks:
This has been a general understanding on the banking performance and comparison between
conventional banks and Islamic banks. The result revealed that Islamic banks performed better
in the sense of Asset quality, Earning and liquidity. With the recent arrivals of International
banks in Kuwait, conventional banks should have a more focused approach especially within the
Asset quality, earning and liquidity factors. Based on the management values calculated here, it
is recommended that management of the financial segment in both conventional banks and
Islamic banks have to be stronger.

For IBS:
This study totally depended on the IBS reports. From examining these reports and through
authors further investigations few drawbacks were encountered. The capital figure that was
shown within the report was in fact not the actual figure but a prediction. This leads the reader to
a wrong impression of the banks. Further, Islamic banks did not have the capital figures
mentioned in the report. This was another stumbling block toward calculating the capital
adequacy. Other missing values were also found which hindered the calculations and alternative
working scenarios had to be adopted.

Recommendations to IBS would be to standardize the reporting format across all years. They
should take measures towards collecting all required figures across all the banks conventional
and Islamic alike.

47

5.5: FUT UR E ST UDY
This research revealed that a more rigorous assessment is required to understanding the financial
sector performance. Effort should be made to collect the data from the banks directly and a
qualitative interview should be performed with the management primarily to understand the
management quality aspects. Sensitivity was another factor that could not be calculated due to
lack of data. Future study should focus on this by gathering this information from the Central
bank and also the individual banks. The Kuwait Real Estate Bank has been recently changed to
Islamic banking; therefore future study should ensure that this is included within the Islamic
banking category.

Further, a qualitative study with the supervisory authorities of Central Bank of Kuwait and
individual banks will reveal a deeper understanding into the measures used, calculated and the
outcome usage. Various types of tools such as CAMEL can be evident from such a study.

48

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52
APPE NDI X 1: I BS DAT A R E POR T FOR MAT

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MBA THESIS

Comparing Islamic and Conventional Banking

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