What Determines The Profitability Of Islamic Banking

Published Date: 02 Nov 2017

Abstract

In this thesis is investigated which determinants have got an influence on the profitability of Islamic banks. The internal and external determinants have been investigated for the period 2005-2010 for 15 Islamic banks. The determinants that have a significant influence on the profitability are: liquidity, inflation, GDP, money supply and the financial crisis. This means that the external determinants are more important than the internal determinants for the profitability of Islamic banks.

Emal Ahmadi

Anr: 148303

[email protected]

Faculty of economics and business administration

Bachelor thesis Finance

Supervisor: Ayse Terzi

17 -05-2013

1. Introduction

The past years there has been a financial crisis and most of the conventional banks have seen their profit being decreased or even turned bankrupt. Islamic banks didn’t face these problems. The Islamic banks didn’t have to deal the same with the negative effects of the bank and liquidity crises.

The first institution that handled in Islamic modes of financing was established in 1963. Since then Islamic banks have gained a lot of market share in especially Muslim Countries and some non-Muslim countries.

In the last decade the Islamic banking industry has seen an even greater expansion. It is even expected to grow a 15 % annum (Chong and Liu, 2009). Their network has been expanded to over 60 countries, and their asset base has become more than $ 200 billion. This means that Islamic banking has become a worldwide method of financing. There has even been a rise in Islamic banks in non-Muslim countries, like the European Islamic Investment Bank in Great Britain. The Muslims in Great Britain are starting to show an interest in the modes of financing in Islamic banks. The increase of interest in Islamic modes of financing can be mainly explained by the profit and loss sharing method that is being applied by Islamic banking. This shows that Islamic banking is having an expansion, and seeing their profits rising. While the conventional banks are seeing a decline

The importance of knowing the determinants of Islamic banking is to have a performance evaluation to give answers to some questions, and creating a greater insight in the Islamic modes of financing. This can provide a better picture of the Islamic banking world, and provide information for the countries that are involved with Islamic banking.

According the analysis of Hasan and Dridi (2010) Islamic banking fared differently during the financial crisis than conventional banking. In particular loyalty to Sharia principles precluded Islamic banking from financing or investing in instruments that have adversely affected their competitors and lead the financial crisis. The conclusion that was made by Parashar (2010) was that Islamic banks did suffer from the financial crisis but over the period of 4 years performed better than conventional banks.

In this research a regression analysis will be performed. Financial ratios will be used to have a broader understanding of the banks financial condition. The effect of numerous determinants will be tested on the profitability. We will get to know which determinants will be significant for the profitability and which are insignificant. In previous studies the determinants were divided in two sectors:  internal determinants, also called the bank specific determinants and external determinants, which are called the country specific determinants. As a dependent variable the return on assets (ROA) will be used. Some of the factors that will be examined are: size, capital ratio, operating expenses management, liquidity ratio, inflation, GDP per country, money supply per country and the financial crisis

All these variables will be tested with a regression analysis with the ROA as the dependant variable.

All bank data and variables will be obtained from Bankscope database. And previous studies about this subject will be used to build the research. If Bankscope lacks sufficient data on Islamic banks, to complement the data some of the data will be obtained from Islamic banks & Financial Institution Information System. Some of the external determinants like the GDP, inflation and money supply will be obtained from world economic outlook database from international monetary fund.

Background

Islamic banking is banking according to the principles of the Sharia (Islamic law). Sharia is the religious law of Islam as it is expressed in the Qu’ran and the examples of the prophet Mohammed. Central to Islamic banking and finance is the fact that money itself has no intrinsic value. The means of Islamic finance are based on trading. It is forbidden to make money from money by lending money to someone and expecting to benefit from it when receiving it back. The wealth must be earned by legitimate trade and investment in assets. There are two basic principles involving the Islamic banking: the profit and loss sharing paradigm and the prohibition and collection of Riba (interest). First will be discussed what the influence of the Sharia is on the financial transactions in Islamic banking.

The Sharia gives some restrictions on some financial transactions: interest (Riba), insecurity (Gharar), gambling (Maysir), almsgiving (Zakat), Halal activites and having a Sharia board. For instance they cannot invest in sectors that have something to do with alcohol, tobacco or gambling.

The Islamic law prohibits paying and receiving interest or usury. According to the Sharia the payment or acceptance of interest or usury for loans is prohibited. A good definition of Riba is given by Hazrat Shah Waliullah Dehlvi : "Riba` is a loan with the condition that the borrower will return to the lender more than and better than the quantity borrowed."

The Islamic law also restricts Islamic banks from engaging in Gharar. Which is a risky or hazardous sale where the details that are concerning the commodity are unknown or not clear to the parties. According to the Shariah trades that are considered risky and uncertain are prohibited.( Obaidullah, 2001) An Islamic stock market cannot have risky or hazardous sales, which leads to the disallowing of complex products of finance that are not good understood by the people using it. And mandatory disclosures are used to ensure the flow of relevant information

Maysir means speculation or gambling. It is prohibited because it can create wealth with chance instead of productivity.

In addition Islamic banks must be engaged in charity, since one of the main beliefs in Islam is that no brother within the Muslim community should be poor. Zakat (almsgiving) is the most important instrument to redistribute the income from the wealthy to the poor. And within the Muslim community it is mandatory. Elgar (2007)

Islamic banks cannot invest in businesses that are Haram (forbidden) in the Islam. Islamic banks have to engage in activities that are allowed in the Islam. These are called Halal activities. For example it is prohibited to invest in activities such as pornography, pork or alcohol.

The profit and loss sharing

The profit and loss sharing is a method in Islamic banks to comply with the prohibition of interest. This method implies a sharing of risks and profit between parties in a transaction. Literature also supported that interest-free (profit and loss sharing) system is viable and superior to an interest-based system (Chapra, 1985; Mirakhor, 1997). Aggarwal and Youssef (2000) said that the profit and loss sharing principle is accepted in the Islamic world as the cornerstone of financial transactions. According to Beck et al (2010) the profit and loss sharing principle increases the overall risk. Musharakah and Muderaba are such modes that are using the profit and loss sharing.

In the relation between the Islamic bank and the client they will not receive a fixed rate of interest on their loans, but they share in profits and losses ( Aggarwal and Youssef 2000). The Islamic banks try to gather information about the situation of their clients on a frequently base , in order to calculate their share in the profits. Because of the gathering of the information the contracts that are based on the profit and loss principle provide greater stability in the financial markets and show the importance of having long term relationships with their clients. The extra relationship difference between Islamic banking and conventional banking is that in Islamic banking the profits and losses are shared between the client and the banks, which means that the bank is much more dependent on their clients than in conventional banks. This makes it very important for the bank to have a good relationship with the client, so it can help it if needed and thus create better profits.

One of the main conclusions of Hassan (1985) was that Profit and Loss Sharing is likely to be more profitable in the long run from the financiers’ viewpoint in comparison to interest financing. Because you are sharing in the profits and losses, the Islamic banks are less vulnerable to credit risk. According Hassouna (2002) the profitability of Islamic banks is less volatile than conventional banks, thanks to the role of the profit and loss sharing. Smaoui and Salah (2009) found in their research that Islamic banks maintain their profits by engaging in acceptable rates of return for depositors, by the use of profit and loss sharing.

In theory sharing the risk and loss of the venture should happen and it’s called the profit and loss sharing paradigm; however in practice it is found that Islamic banking is not very different from conventional banking, Chong and Liu (2009). Their findings suggest that the growth in Islamic banking is largely driven by the Islamic resurgence worldwide rather than by the advantages of the profit and loss sharing paradigm. Khan and Ishaq (2008) wanted to highlight the growth of Islamic banking in the finance world and investigated the trends of Islam banking industry worldwide to tell us about the strengths, weaknesses, future prospects and ambitions of the Islamic banking.

There are two types of contracts within Islamic banking: contracts with the profit and loss principle or with the mark-up principle. The types of contract with the PLS principle are : Muderaba and Musharaka.

The equivalent of a joint venture in the Islamic banking is called Musharaka and the meaning is sharing. Like a joint venture the bank and the client both provide capital. It conforms to the theory of profit and loss sharing. The profits are shared in pre agreed ratios but the losses are determined by the proportion of equity invested. When Muderaba is used an investor entrusts capital to an agent for a project, this means that it’s not like Musharaka a joint venture because only one party provides the capital. The profits are based on a pre-agreed ratio. In a case of loss the bank earns no return or has a negative return and the agent receives nothing for his compensation.

Without the PLS principle are the Ijara, Murebaha and Istisna. Leasing of goods is a popular mode of financing in Islamic banks and it consists of 2 different methods: Ijarah and Ijara Wa Iqtina. In the use of Ijarah the Islamic bank leases the assets to a client. According to Zamir Iqbal (1997) about 10% of Islamic financial transactions are leasing. The lease payments must be agreed in advance for the period and contains an amount of profit for the bank. The difference between Ijarah and Ijarah Wa Iqtina is the fact that the lessee has got the option of owning the asset at the determination of the lease in Ijara Wa Iqtina. The loss and destruction risks mainly remain with the lessor, unless caused by the negligence or default of the lessee. Murabaha is the most popular mode of financing in the Islamic world is. It is also called mark up financing or cost plus financing. An Islamic institution buys a tangible asset at the request of its customer (it has made a promise to purchase the good from the bank). Then the bank will sell the asset to the customer with a sale price that consist the mark up profit for the bank. The mark up of the bank cannot be altered in the lifetime of the contract. The size of the mark up is determined by an interest rate index, the credit rating of the customer, the size of the transaction and the type of good that is being financed. Historically this mode of financing is mostly used in trade finance ( Zahar and Hassan 2001 ). The Islamic bank has got a few constraints: it cannot earn excessive profits from the client, if this happens there are remedies of returning the excessive profit back to the customer. The form of financing called Istisna is basically the same as a futures contract. A sale of a commodity in the future for cash price. This means that the price is advanced to the seller. Who delivers a commodity on a specified date. Once the commodity is delivered, it will be sold by the bank to a buyer, with a price that is higher than the purchase price paid by the bank to the seller

Comparison Islamic banking and conventional banking

 In conventional banking the money that is deposited by clients is lent out to borrowers. The bank makes revenue by the difference of interest that is paid to depositors and the interest that is paid by the borrowers. The main revenue of conventional banks comes from the interest revenues obtained. Therefore in conventional banking the interest based principle is used.

Islamic banking prohibits the use of interest (Riba), and is based on the profit and loss principle between bank and borrower. Because of the profit and loss sharing a relationship between the borrower, lender and intermediary is found that is built on financial trust and partnership (Yudistira 2003). Islamic banks mix commercial banking and investment banking operations. Money plays a different role in the use of Islamic banking: money is used to facilitate transactions and for trading, in conventional banking it is used as a commodity that is bought and sold by the use of interest. Another big difference between the two types of banking is: An Islamic bank cannot demand payments from the client if he is not capable of paying, but they can demand the payment if there is a case of negligence or mismanagement by the client. This means that the Islamic banks take in mind the borrowers’ financial situation.

The Islamic banks have restrictions on investment decisions, there are six religious features that must be followed in Islamic banking (Elgar 2007) and these features are the main differences between Islamic and conventional banking.

The prohibition of Riba ( interest )

Maysir (gambling) is forbidden

Transactions should be free from Gharar ( riskiness or uncertainty)

Zakat ( almsgiving ) must be paid by the bank to a charity

The businesses of the bank are based on halal activities

All activities should be in line with Islamic principles, and there should be a special sharia board that supervises and advises the bank on the property of transactions .Elgar (2007).

Islamic banking must be consistent with the principles of the Sharia. All Islamic banks are governed by a Sharia Advisory Board, who is responsible to ensure that all the activities performed by the bank are in compliance with Sharia. According Warde (2000) the Sharia board creates an extra layer of governance, which creates a difference between Islamic banking and conventional banking.

The main difference with conventional banking is: Islamic laws prohibit paying and receiving interest. It encourages all parties to share the risk and loss of the venture (Islamic Finance Gears Up, Mohammed El Qorchi). Anouar Hassoune came to several conclusions in her paper’ Islamic banks profitability in an interest rate cycle’: ‘thanks to profit sharing an Islamic bank is effectively in position and can make its profit less volatile over the cycle’. Islamic banks benefit from market imperfection which decreases the cost of funding, and empirical evidence tends to show that therefore Islamic banks are more profitable than conventional banks. Not all the conclusions are positive because Islamic bankers are constrained by several weaknesses in terms of liquidity, concentration risks and operational efficiency.

Nog een stuk

Because of the Sharia and the restrictions on investment decisions that the Islamic banks face, the Islamic banks cannot make the same profit in some sectors that a conventional bank makes. In contrary to conventional banks, Islamic banks are prohibited to invest in certain sectors like: liquor, pork, gambling, pornography , because of the Sharia. This means that they are not able to compete and make profits in these sectors.

This paper will proceed as follows: section 2 will contain the literature review, section 3 will be the empirical research, section 4 will conclude the data analysis. And section 5 contains the conclusion.

2. Literature review

Factors influencing the profitability

There have been a few studies trying to determine the factors that influence the Islam banking profitability. Hassan and Bashir (2003) examined the performance indicators of Islamic banks worldwide during 1994-2001. They investigated the effect of : net interest margin, before tax profit divided by total assets, return on assets and the return on equity on the profitability of Islamic and conventional banks. They used 43 conventional banks and Islamic banks for their study. One of the main results obtained from this research was the fact that high capital and loan to assets ratio lead to a higher profitability. In general these results confirms to previous findings. One of the findings that were surprising was a strong positive correlation between overhead and profitability. The overhead ratio was used to provide information on the operating costs of the Islamic banks and it was expected that a high overhead ratio would impact the performance negatively and a lower overhead ratio can impact the performance positively. But the results of the research indicated the opposite. Which meant that a high overhead had a positive correlation with the profitability. This can be interpreted that banks with high profits have to deal with higher wages and salaries.

Capital, leverage overhead, loan and liquidity ratios were used as proxies for the banks internal measures, macroeconomic indicators, taxation, financial structure and country dummies were used for the external measures.

In a study performed by Abdel-Hameed M. Bashir (1999) the effects of scale of the performance of Islamic banks were examined. One of the findings was that Islamic banks become more profitable when they grow in size. This indicates that size is an important determinant of the Islamic banking profitability.

Some studies investigated the difference between the Islamic banking and conventional baning, like in the paper of Samad en Hassan (1999) they investigated the Islamic banks and the conventional banks in Malaysia. They divided their results into four categories: profitability ratios, liquidity ratios, risk and solvency ratios and the commitment to economy and Muslim economy. Their results showed that Islamic banks had better liquidity and risk and solvency ratios have. The profitability ratio was higher with the conventional banks.

According to Van Horne and Wachowicz (2005) the ROA refers to the profitability of the assets of the firm after the operating expenses and taxes are deducted. Many studies about the profitability of banks have used the ROA as the dependant variable. In this study the ROA will also be used as the dependant variable measuring the profitability of Islamic banks. The return on assets is a reliable indicator of how profitable a company is relative to its total assets and it measures the amount of earnings derived from the assets they control. Previous studies about the profitability of banks have also used the ROA to measure the profitability. Alkassim (2005) used the ROA as a dependant variable about the profitability of Islamic banks in the GCC countries. Bashir and Hassan ( 2004) believed that the ROA showed the effectiveness of a bank. And therefore is a great measurement of the profit of a bank. Aktar, Raza, Orangzab and Akram (2011) also used the ROA to measure the profitability of Islamic banking in Pakistan.

The factors that will influence the profitability can be divided in two sectors: the internal and external determinants. For internal determinants I have chosen: the bank size, capital ratio, operating expenses management and the liquidity ratio. For external determinants I have chosen: the inflation, gross domestic product (GDP) , money supply and the market share.

The size of a bank has been claimed to explain the profitability of a bank in previous relating studies. The size of a bank could be referring of the total assets of the bank. In theory the larger the bank is, the lower the cost of production will be. The size of a bank has got a significant influence on the profitability. By previous studies contradictory findings have been obtained. Hameetemam et al. (2000) found negative relationship between bank size and net profit before income. Allen and Rai (1996) show that small banks have advantages for economy of scale. Hunter and Timme (1993) indicate positive relationship for size of bank assets and non-traditional banking profit. Alexiou and Voyazas (2009) find that large banks in terms of assets have a positive correlation with profitability. A reason for the positive effect of size on the profitability can come of the economies of scale that they receive (Haron 2004). Large banks can enjoy the economies of scale, and produce their services cheaper than smaller banks. This can lead to higher profits for large banks. By contrast Cihak and Hesse (2008) concluded that small Islamic banks tend to be more financial stable than conventional banks.

The capital ratio of a financial institution can be an explanatory factor for determining the profitability. According to Vong and Chan (2009) capital will positively affect the profitability, because the more capital there is the safer the bank is. And this can lead to higher profits. Haron (2004) also found that the internal variable capital has a significant positive relation with the profitability of an Islamic bank. Contrary to the results obtained from Vong and Chan (2009) and Haron (2004), Hassan and Bashir (2003) found a statistically negative relationship between capital and profitability. According to Parashar (2010) Islamic banks had better profitability ratios and were better capitalized than conventional banks over the period of 2006-2009.

The operating expenses influence the profitability of a bank. Banks operating expenses consists of the wages and salaries, and the costs of running the office. It is expected that there is a negative relationship between the operating expenses and the profitability. The lower the operational costs the more profit there will be left over. This was also the case in the study performed by Ramadan, Kilani and Kaddumi (2011), in which they found a negative significant effect of operating expenses on the ROA. On the contrary Bashir (2003) found a positive relation between the operating expenses and the profit. This means that higher operational costs could lead to higher profitability. Beck et al (2010) demonstrated that Islamic banks face lower operations costs and cost-income ratios than conventional banks, which makes the Islamic banks more efficient.

The level of liquidity of a bank can be a factor that determines the profitability. Bourke (1989) found a positive relation between the level of liquidity and the profitability, which indicates the higher the liquidity the higher the profit will be. In a more recent study about the profitability of Islamic banks in Malaysia Idris et al (2011) found that there is a insignificant relation, which means that it is not a determinant of the profitability of Islamic banks. Some of the studies performed on Islamic banks found a negative relation between the liquidity and the profitability and that this is mostly caused in Islamic banking due to the profit and loss sharing principle.

Inflation plays an important role in the banking industry. Levine and smith (2000) used various regression techniques and found that there is a strong non linear relationship between inflation and the financial sector performance. In most of the studies performed about the banks profitability the Consumer price index (CPI) was used as a proxy for the inflation. Vong and Chan (2009) found in their study that the inflation rate had a strong impact on the ROA. Boyd et al (2000) concluded a negative relation between the inflation and the profit of banks. Some studies divide the inflation in two options: anticipated or unanticipated inflation. Because banks will react different if they already know that there will be inflation.

The definition of Gross domestic product is: The monetary value of all the finished goods and services produced within a country's borders in a specific time period. And it measures the total economic activity within a economy. Levine and Zevros (1998) suggest that there is a positive relation between the growth of the economy and the performance of the banks. This confirms the findings of Pasiouras and Kosmidou (2007) in which the economic growth is statistically significant and positively related to domestic and foreign banks in 15 European countries. Srairi (2009) studied also the determinants of Islamic banking profitability in the GCC countries and found a statistically and positively relationship between the GDP and the ROA.

The money supply measures the total amount of monetary assets in a economy. It can be calculated as only currency in calculation and instruments that can be converted to currency on demand. Bourke (1989) used the money supply as a proxy for the market growth. And he believed that a growth in the total market by the money supply could produce an environment for profits to increase. Bourke (1989) found a significant and positive relationship between the money supply and the bank’s profitability. Haron and Azmi (2004) studied the effects of money supply on Islamic banking profitability and they found a significant positive long run relationship between the money supply and the profitability.

Competition will decrease the profit of a bank, because the profit has to be shared with competitors now, which shows that the market share has got a influence on the profitability of the bank. Hassan and Bashir (2003) found that competition with other Islamic banks has a negative influence on the Islamic banking profitability. They used the number of banks in order to determine the competition of banks on the profitability. Heggested and Mingo (1976) used the market share as a measurement of competition and found a positive relation between the market share and the profitability of the bank.

The financial crisis has affected the Islamic banks too, but in a different way than conventional banks. The initial impact of the crisis in 2008 was limited on the profit of Islamic banks. But in 2009 Islamic banks in some countries faced larger losses than the conventional banks. A reason for this might be the result of the risk taking of Islamic banks. (Hasan and Dridi 2010).

Because of the lack of trust in financial institutions the financial crisis is difficult to solve. In Islamic banking the profit and loss sharing creates a relationship between the bank and the lender, and therefore creates a trust between the client and the bank. This increases the reliability and trust in the financial institutions. In conventional banking it is much harder to create a trustful relationship between the client and the bank. This makes it harder to find a solution for the crisis.

Habib Ahmed (2009) identifies in his paper, the failure of risk mitigation at different levels as the main cause of the crisis. The principles of Islamic finance would have prevented the occurrence of the crisis. Therefore Islamic banks don’t have to cope with the consequences of the financial crisis. The results obtained by Parashar (2010) suggested that the Islamic banks suffered more from capital adequacy and leverage changes during the crisis, while conventional banks had seen a greater effect of the crisis on their ROA and their liquidity.

The main question that will be investigated in this research is: What determines the profitability of Islamic banking. This will be done with the help of some background and philosophy of Islamic banking, the main differences between Islamic banking and conventional banking, the influence of the crisis on Islamic banks and the effect of the determinants on the Islamic banking profitability.

3. Empirical research

Data

The main data source used in this research is Bankscope. The data in the research is for a period of 6 year, 2005, 2006, 2007, 2008, 2009 and 2010. The financial crisis is included in the research as a dummy variable for the years 2008, 2009 and 2010.

Because of the unavailability of sufficient data on Islamic banks for the period 2005-2010 a total of 15 Islamic banks will be used. In Bankscope there is consolidated and unconsolidated data of Islamic banks, therefore the Islamic banks with consolidated data and sufficient data of the variables for the period 2005-2010 will be used for this research. With sufficient data is meant that there will be little to none missing variables of each bank for the period 2005-2010 . These 15 Islamic banks are spread around different countries: 4 of the Islamic banks are in the United Arab Emirates, 3 are in Bahrain, 2 are in Jordan, 2 are in Syria, 1 is in Qatar, and 1 is in Yemen, 1 in Sudan and 1 in the United Kingdom.

If Bankscope lacks sufficient data on Islamic banks, to complement the data some of the data will be obtained from Islamic banks & Financial Institution Information System. Some of the external determinants like the GDP, inflation and money supply will be obtained from World Economic Outlook database from international monetary fund. All this data will be used to examine the relationship between the profitability and the potential factors which are expected to explain the profitability.

Model

The following specification will be tested:

Yi = β1X1 +...+ βkXk +βk+1D1+ εi

D1 contains the dummy crisis and ε is the error variable. The dependent variable represents the ROA and the independent variables include: the bank size, capital ratio, operating expenses management, the liquidity ratio, the inflation, gross domestic product (GDP), money supply, market share and the crisis

This leads to the following model:

ROA = B0+B1size+B2capital ratio +B3 operating expenses management +B4 liquidity +B5 inflation + B6 GDP +B7 money supply + B8 market share+ B9 crisis

The dummy variable crisis will get the value 1 in the years of the financial crisis, which are 2008, 2009 and 2010.

In previous studies about the profitability of Islamic banks, the ROA (return on assets), ROE (return on equity) and the PBT (profit before taxes) were used as dependent variables. In this study only the ROA is used as a dependent variable. According to Flaimini, Mcdonald and Schumacher (2009) the ROA is a better proxy than ROE and the profit before taxes to determine the bank’s profitability.

The following table describes how the variables are measured.

Table 3.1

Variable

Measurement

Return on assets

Return on assets of a bank

size

Measured in terms of total assets

Capital ratio

Total equity/total assets

Operating expenses management

Operating operating expenses/total assets

liquidity

Loan of bank/total assets

inflation

Inflation index ( 2005=100)

GDP

GDP growth annual %

Money supply

Money and quasi money growth annual %

Market share

Total deposit of bank to total deposit of Islamic bank industry

crisis

The years 2008,2009 and 2010

Although previous studies have studied the effect of market share, we didn’t include it in our study because of data shortage.

Hypotheses

Before starting the regression analysis, some hypotheses will be formed about the influence of the variables on the ROA. The internal determinants include, size, capital ratio, operating expenses management and liquidity. The external determinants include the GDP, money supply, market share and the financial crisis.

Hypothesis 1: The size is positively related to the ROA

Since large size enables banks to offer a large menu of financial services at lower costs (Hassan and Bashir 2003), it will be positively related to the profit before taxes. Large banks have higher total assets. Goddard, Molyneux, and Wilson (2004) found in their study a significant positive relationship between total assets and profitability.

Hypothesis 2: the capital ratio is positively related to the ROA

A bank with a high capital has a better ability to withstand it losses, and is better protected to operation losses. In Islamic banking it is prohibited to invest in risky activities. According to the risk-return trade of theory, risky investments could lead to a higher income, but according to Abreu and Mendes (2002) a well capitalized bank could lead to better and higher income. Therefore a positive relation between capital and banks profitability is expected. Vong and Chan (2009) found in their study a significant positive relationship between the capital and profitability. But Bashir and Hassan (2003) found a negative relation between capital and profitability.

Hypothesis 3: The liquidity is negatively related to the ROA

The liquidity is expected to be negatively correlated on the profitability. A bank with a high liquidity is holding more money instead of lending it to their clients, which means less income from loans, and a lower ROA.

Hypothesis 4: The operating expenses management is negatively related to the ROA

The higher the expenditures are in a bank, the lower the profitability will be, because of higher operational costs. Therefore it is expected to have a negative impact on the ROA.

Hypothesis 5: The GDP is positively related to the ROA.

According to Wasiuzzaman and Tarmizi (2010) the GDP is expected to have a strongly positive effect on the profitability measures. During a rise in the economy, the credit quality seems better, which means a lower default rate which could lead to a rise in profits.

Hypothesis 6: The inflation is positively related to the ROA

According to Vong and Chan (2009) if an Islamic bank makes an accurate forecast on the changes caused by the inflation, it can make a better decision on the rate of profit and loss sharing and therefore increasing their profits.

Hypothesis 7: The money supply is positively related to the ROA

According to Haron and Azmi (2004) the money supply has got a positive relation with banks profitability. An expansion in the market could lead to produce higher profits (Bourke 1989)

Hypothesis 8: The crisis is negatively related to the ROA

According the results of M Hasan, J Dridi (2010), Islamic banks average profitability for 2008-2009 was similar to that of conventional banks. And suggesting that higher pre crisis profitability was not driven by a strategy of greater risk taking.

4. Data Analysis

In the previous chapter the regression model and the variables are explained. In this chapter the regression analysis will be performed. Before executing the regression analysis, there will be tested for correlation between the determinants and a correlation matrix will be performed, because this can have a significant influence on the outcome and finally the hypotheses will be tested. In the appendix the correlation matrix and the regression analysis can be found. And in order to test the usefulness of the model an F-test will be performed which can be found in the appendix.

De data that has been analyzed consists of 15 Islamic banks that are distributed in 8 different countries.

In SPSS a regression model has been run for the determinants of the profitability of Islamic banks.

This model is shown in the table below.

Beta

Test Statistic

Significance

(Constant)

-8,370

-3,503

,001

Size

-1,597E-6

-,439

,662

Capital

-,001

-,091

,928

Operating expenses

-,044

-,185

,853

Liquidity

,028

3,277

,002

Inflation

,059

2,607

,011

GDP

,265

4,417

,000

Money supply

,077

3,142

,002

Crisis

-1,929

-2,507

,014

Dependent variable: Return on Assets.

The R squared of this model was 0,574. This means that this model explains 57,4% of the variation on the return on assets. The variables that are significant with a significance level of 0,05 are : liquidity, inflation, GDP, money supply and the financial crisis. Also the usefulness of the model was tested by a F-test, which can be found in the appendix. The F test resulted in the conclusion that the model is useful with a very small p-value 2,57542E-12.

The size has got a negative insignificant relation to the ROA. This negative relation is not in line with my hypothesis. Hameetemam et al (2000) also found a negative relationship between the size of the bank and the net profits. And according to Allen and Rai (1996) small banks have advantages for economy of scale, which results in better profits. Bashir (2000) concluded that size negatively affects the profitability of Middle Eastern Islamic banks. Ling and Zhang (2008) also obtained an insignificant relation of size with the profitability. Wasiuzzaman and Tarmizi (2010) obtained the same result, that the size of the Islamic bank does not have any influence on the profitability of Islamic banks in Malaysia.

The capital ratio seems to have a negative insignificant relation, and not a positive relation like in the hypothesis. This negative relation between capital and the profitability was also found by Bashir and Hassan (2003). Asthanasoglou et at (2006) found that capital was negatively related to profitability. The negative relation can happen because well capitalized banks are less risky and are supposed to be safer, therefore the profits are expected to be lower Wasiuzzaman and Tarmizi (2010). According to the results of this study the capital ratio does not influence the profitability of Islamic banks.

Operating expenses are insignificant negatively related to the ROA. This negative correlation is in line with my hypothesis. When the operational costs are high, this reduces the profitability, because of higher costs. But it seems that the operating costs are not significant in explaining the profitability.

The variables liquidity, inflation, GDP money supply and the financial crisis were significant with a significance level of 0,05. This means that the external determinants have a great impact on the profitability of Islamic Banks. This confirms previous studies, like Wasiuzzaman and Tarmizi (2010), they also came to the conclusion that the macroeconomic policies are important factors in contributing to the profits.

According to the results the liquidity is significant and has a positive relationship with the ROA. This is not in line with my hypothesis. Bashir (2000), Athanosoglou et al (2006), Vong and Hoi (2009) and Sufian and Habibullah (2009) also found a positive relation between the liquidity and the profitability. The liquidity is the ability to convert the assets into cash, which means if the bank has enough cash to meet the short term liabilities and avoid bankruptcy or losses. This can be a reason for the positive relationship between liquidity and the profitability.

Inflation has got a positive significant relation with the ROA and this is also according the hypothesis. Vong and Chan (2009) also found a positive relation with the profits of a bank, and according their study an Islamic bank can create an increase in their profits by making an accurate forecast on the changes caused by the inflation. This was in accordance to the study of Bashir (2000), athanosoglou et at (2006).

The GDP shows to have a positive significant relation with the ROA. This is in accordance to the hypothesis and confirms with previous studies done by Levine and Zevros (1998), Pasiouras and Kosmidou (2007) and Srairi (2009) about the profitability. According the study done by Vong and Chang (2009) during a rise in the economy, the credit quality seems better, which means a lower default rate which could lead to a rise in profits.

The money supply has got positive significant relation to the ROA, this also confirms the hypothesis. With a higher money supply, there will be an expansion in the market which could lead to higher profits (Bourke 1989). Both Bourke (1989) and Haron and Azmi (2004) found a positive significant relation between the money supply and the profitability.

The financial crisis has got a negative significant relation with the ROA, thus this confirms the hypothesis that has been made. This means that Islamic Banks, just like conventional banks, did suffer from the financial crisis, and saw their profits declining after 2007. This is partly confirmed by a previous study done by Parashar (2010), in which the results suggested that Islamic banks did suffer from the Crisis, but that conventional banks had seen a greater effect of the crisis on their ROA.

5. Conclusion

The main research question of this research was:

What determines the profitability of Islamic banking?

By researching previous studies the most important determinants were chosen and divided in internal and external determinants: the bank size, capital ratio, operating expenses management, the liquidity ratio, the inflation, gross domestic product (GDP), money supply, market share and the crisis. In section 4 the influence of these variables on the ROA has been examined. This has been examined on 15 Islamic banks in different countries. The variable market share is been excluded out of the model, because of a lack of sufficient data. In this study only the Return on Assets has been used as a dependant variable, and the Return on Equity and the profit before taxes are not used as profitability ratios.

For the Islamic Banks the liquidity, inflation, GDP, money supply are positive correlated with the ROA. And the size, capital ratio, operating expenses ratio and the crisis were negatively correlated. It is important to mention that the determinants size, capital ratio and the operating expenses ratio were insignificant. These are all internal determinants. It can be concluded that the external determinants have the most influence on the ROA, since inflation, GDP, money supply; the crisis and the liquidity ratio are significant. This means that the macroeconomic policies for an Islamic bank are very important, for determining the profitability.

Some researchers have conducted research by comparing Islamic banking with conventional banking. For future research it would be interesting to research the main differences between the determinants of Islamic banking and conventional banking, this for a longer period and including differences in countries. This should be done in order to come up with a strategy to attract more non-Muslims to Islamic banking. So that Islamic modes of financing would attract more clients, and raise their market share in global banking.

Appendix

To test the usefulness of the model an F-test will be performed

(i) Hypothesis test: H0: β 1 = β 2 = …… = β 9 = 0 vs. H1: At least one of β 1…. β k ≠ 0;

(ii) Test statistic: F = (SST-SSE)/ k

SSE/(n – (k + 1))

(iii) Rejection region: f > F0,05; 8;81 = 2,054882

(iv) Val = [(726,068– 309,542)/8] / [309,542/81] = 13,6244

P-value = P(F8;81 > 13,6244) = FDIST(13,6244;8;81) = 2,57542E-12

(v) conclusion : reject H0 since val is larger than the critical value 2.054882.

The model is useful

List of Islamic Banks Used, and City

Dubai Islamic Bank plc

DUBAI

Abu Dhabi Islamic Bank - Public Joint Stock Co.

ABU DHABI

Qatar Islamic Bank SAQ

DOHA

Emirates Islamic Bank PJSC

DUBAI

Sharjah Islamic Bank

SHARJAH

Jordan Islamic Bank

AMMAN

Bahrain Islamic Bank B.S.C.

MANAMA

Tadhamon International Islamic Bank

SANA'A

Albaraka Islamic Bank BSC

MANAMA

Syria International Islamic Bank

DAMASCUS

ABC Islamic Bank (E.C.)

MANAMA

Tadamon Islamic Bank

KHARTOUM

Jordan Dubai Islamic Bank

AMMAN

European Islamic Investment Bank Plc

LONDON

Cham Islamic Bank SA

DAMASCUS

De table below shows the correlation matrix.

Correlations

Dcrisis

size

capital

operating expenses

inflation

liquidity

gdp

moneysupply

Dcrisis

Pearson Correlation

1

,157

-,013

,160

,723**

,157

-,358**

-,458**

Sig. (2-tailed)

,139

,904

,132

,000

,139

,001

,000

N

90

90

90

90

90

90

90

90

size

Pearson Correlation

,157

1

-,201

-,210*

,447**

-,144

-,099

-,090

Sig. (2-tailed)

,139

,057

,047

,000

,175

,353

,400

N

90

90

90

90

90

90

90

90

capital

Pearson Correlation

-,013

-,201

1

,546**

-,170

-,147

-,155

-,130

Sig. (2-tailed)

,904

,057

,000

,109

,167

,146

,220

N

90

90

90

90

90

90

90

90

operating expenses

Pearson Correlation

,160

-,210*

,546**

1

,012

-,177

-,144

-,014

Sig. (2-tailed)

,132

,047

,000

,907

,096

,177

,894

N

90

90

90

90

90

90

90

90

inflation

Pearson Correlation

,723**

,447**

-,170

,012

1

,055

-,132

-,216*

Sig. (2-tailed)

,000

,000

,109

,907

,606

,214

,041

N

90

90

90

90

90

90

90

90

liquidity

Pearson Correlation

,157

-,144

-,147

-,177

,055

1

,072

,141

Sig. (2-tailed)

,139

,175

,167

,096

,606

,499

,185

N

90

90

90

90

90

90

90

90

gdp

Pearson Correlation

-,358**

-,099

-,155

-,144

-,132

,072

1

,410**

Sig. (2-tailed)

,001

,353

,146

,177

,214

,499

,000

N

90

90

90

90

90

90

90

90

moneysupply

Pearson Correlation

-,458**

-,090

-,130

-,014

-,216*

,141

,410**

1

Sig. (2-tailed)

,000

,400

,220

,894

,041

,185

,000

N

90

90

90

90

90

90

90

90

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).

The tables below provide the information about the regression analysis:

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

1

,757a

,574

,532

1,95487

a. Predictors: (Constant), Dcrisis, capital, liquidity, size, gdp, moneysupply, operating expenses, inflation

ANOVAb

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

416,526

8

52,066

13,624

,000a

Residual

309,542

81

3,822

Total

726,068

89

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

1

(Constant)

-8,370

2,389

-3,503

,001

size

-1,597E-6

,000

-,039

-,439

,662

capital

-,001

,014

-,008

-,091

,928

operating expenses

-,044

,239

-,017

-,185

,853

liquidity

,028

,008

,264

3,277

,002

inflation

,059

,022

,332

2,607

,011

gdp

,265

,060

,371

4,417

,000

moneysupply

,077

,024

,288

3,142

,002

Dcrisis

-1,929

,769

-,340

-2,507

,014

a. Dependent Variable: ROA

a. Predictors: (Constant), Dcrisis, capital, liquidity, size, gdp, moneysupply, operating expenses, inflation

b. Dependent Variable: ROA