Factors Influencing the Profitability of Conventional and Islamic Commercial Banks in GCC Countries

Factors Influencing the Profitability of conventional and Islamic commercial Banks in Gcc countries

Samir Abderrazek Srairi

Abstract: This paper examines the impact of bank characteristics, macroeconomic indicators and financial structure on the profitability of conventional and Islamic commercial banks operating in the Gulf cooperation council (Gcc) countries for the period 1999–2006. Empirical results show that the profitability of both conventional and Islamic banks is affected mainly by three variables: capital adequacy, credit risk (with different sign) and operational efficiency. furthermore, the liquidity ratio and financial risk have only a positive impact on Islamic banks’ profitability. we also found that all macroeconomic determinants, with the exception of inflation rate, are positively significant in explaining profits. finally, as for the effect of financial structure on return on average assets (roAA), the empirical estimation confirms the complementarities between bank and equity market in Gcc countries. In the case of conventional banks, concentration is favourable to banking sector performance. However, there is no evidence indicating

a relationship between banking development and profitability.

JEL Classification: G21, C23, O53, P43.

I. IntroductionThe economies of the Gulf cooperation council (Gcc) countries (Bahrain, Kuwait, oman, Qatar, saudi Arabia and the United Arab Emirates) have witnessed a boom in the last five years as a consequence of record-high oil

Samir Abderrazek Srairi, Assistant Professor of finance, riyadh community college, King saud University, Kingdom of saudi Arabia.

© 2009, international association for islamic economics

Review of Islamic Economics, vol. 13, no. 1, 2009, pp. 5–30.

6 Review of Islamic Economics, vol. 13, no. 1, 2009

prices and increased confidence in the region’s future. The Gcc economies are in a relatively strong position as compared to ten years ago and they have collectively shown growth rates much above the world average. In fact, the Gcc banking sector was a main beneficiary of the very favourable economic environment. Indeed, during the period 2001–2006, the total assets of banks, which amounted to Us $310 billion in 2001, have more than doubled to reach over $650 billion in 2006. In terms of profitability, return on equity (roE) for conventional and Islamic banks averaged at 14.5% in 2001, and rose rapidly to 22% in 2006.1 Despite this robust growth, commercial banks in Gcc countries are faced with numerous changes that could impact their profitability, indeed their existence. These changes include the sector’s declining exposure to the government, the opening up of certain markets to foreign competition, the expansion of the private sector and the increase of lending, particularly personal lending, and, finally, the rapid growth of Islamic banking.

In the last two decades, Islamic banks have grown in size and number around the world, especially in Gcc countries and in south Asia. According to the Islamic Development Board web site, there were in 2006 about 400 banks licensed as Islamic banks operating in more than 70 countries worldwide. moreover, with the trend towards Islamic financing growing rapidly, most conventional banks in the Gcc countries are now offering Islamic products and are swiftly gaining market shares in the Islamic banking arena. The reason for this thrust into retail Islamic banking is customer demand, which is more inclined to Islamic products as opposed to conventional ones.

Islamic banks have several distinguishing features (Ariff, 2007; olson and Zoubi, 2008; chong and liu, 2008). The first principle is the prohibition of interest (riba) regardless of its form or source. Hence, Islamic banks are not allowed to offer or fix a rate of return on deposits and are not allowed to charge interest on loans. The concept of interest is replaced by the profit-and-loss sharing (Pls) paradigm. Under the Pls paradigm, the assets and liabilities of Islamic banks are integrated in the sense that borrowers share profits and losses with the banks, which in turn share profits and losses with the depositors. A second principle of Islamic banking is that it avoids investing in any economic activity that is not considered to be of long-term interest to society (e.g. gambling, production and sale of liquor). Therefore, an Islamic bank will not engage in financing activities that are considered unequivocally unlawful (haram) for muslims. finally, the third principle is that any contract of any financial service must have up front all dangers

7Review of Islamic Economics, vol. 13, no. 1, 2009

pre-announced or declared. In Islamic contracting, gharar (uncertainly and risk) is not permitted. Gambling and derivates such as futures and options, therefore, are considered un-Islamic products.

In view of the rapid growth of the new form of banking, several recent researches have examined and compared performance between Islamic and conventional banks. for example, olson and Zoubi (2008) compare conventional and Islamic banks in the Gcc region over the 2000–2005 period, using 26 financial ratios. They argue that Islamic banks are profitable but less efficient than conventional banks. Their results indicate also that Islamic banks are operating with greater risk because they maintain smaller contingency reserves for bad loan-like products. In contrast, samad and Hassan (1999) found that Bank Islam malaysia Berhad is less risky compared to a group of eight conventional banks, because it has more equity capital and its investments in governments securities are much larger than the conventional banks. Based on the banking system in malaysia, chong and liu (2008) attempted to establish whether Islamic banking is really different from conventional banking. To this end, they compared Islamic investment rates and conventional deposit rates on savings deposits as well as time deposits of various maturities, ranging from one to twelve months. Their results suggest that the Islamic deposits, in practice, are not very different from conventional deposits. They also show that only a negligible portion of Islamic bank financing is strictly Pls-based and that Islamic deposits are not interest-free, but are closely pegged to conventional deposits.

Besides carrying on the comparison between Islamic and conventional banks, the aim of this study is to examine the determinants of commercial banks’ profitability in Gcc countries. we intend to analyse how a bank’s specific characteristics and the overall banking environment (macroeconomic indicators and financial structure) affect the performance of commercial banks. The research uses panel data of Gcc banks that covers the period 1999–2006, and utilizes linear regression estimated by three empirical models (pooled ordinary least square, fixed effect model, and random effect model).

This paper makes several contributions. It is the first study for the Gcc countries that analyses the determinants of banks’ profitability. It builds on Bashir and Hassan’s (2003) research which examined the factors influencing banks’ profitability only for Islamic banks in four countries (Bahrain, Kuwait, Qatar, UAE) of the Gcc region. furthermore, we attempt to be the first to distinguish between conventional and Islamic banks. Previous studies


(Hassan and samad, 2003; olson and Zoubi, 2008) that examine conventional and Islamic banks focus on financial characteristics that differentiate these two groups of banks and not on whether the internal and external determinants of profitability among conventional and Islamic banks are different. Also, this research uses data from an important number of conventional and Islamic banks (66 banks) and a more recent time-frame by examining the period 1999-2006. finally, we examine a variety of variables by introducing internal and external factors that may be important in explaining profits. The group of internal characteristics of banks involves capital adequacy, liquidity, asset quality, financial risk, operational efficiency and size. The second group of external factors includes macroeconomic variables (inflation, growth of GDP and money supply) and financial structure (banking sector development, financial market development, and concentration).

The remainder of the paper is organized as follows: section 2 provides a brief review of the related literature. The Gcc economies and banking sector are described in section 3. section 4 presents the data, variables and empirical methodology used in the study. section 5 describes the data and discusses the results. The final section is a conclusion.

II. Literature ReviewThe determinants of banks’ profitability have long been a major focus of banking research in many countries around the world. The literature classifies the determinants of profitability as internal and external. Internal determinants concern banks’ specific characteristics and include measures like bank size, asset quality, capital ratios, liquidity and operational efficiency. External determinants are not related to bank management, but reflect financial industry (concentration, financial market development, and banking sector development) and macroeconomic environment such as inflation rate, interest rate and growth rate in GDP. The link between banks’ profitability and internal and external factors has been investigated empirically by means of cross-country regressions, times series analysis and panel studies or as country case studies. The research undertaken has applied various methods, including parametric (stochastic frontier approach: SFA, distribution free approach: DFA, thick frontier approach: TFA) and non-parametric approaches (data envelopment analysis: DEA, free disposal hull: FDH).

In this section, we will focus on studies that examine the Arab banking system (Bashir and Hassan, 2003; maghyerech and shammout, 2004; Ben naceur and Goaid, 2006; srairi, 2008), but also on recent research


(staikouras and wood, 2003; Kosmidou and Pasiouras, 2007; Athanasoglou et al. 2008) that analyses the effect of bank-specific, industry-specific and macroeconomic determinants on bank profitability. The empirical results of these studies vary significantly because, across countries, commercial banks have to deal with different macroeconomic environments, different explicit and implicit tax policies, deposit insurance regimes, financial market conditions and legal and institutional realities (Dermirguc-Kunt and Huizinga, 1999). However there exist some common elements that we will try to analyse in this paper.

single-country studies investigate the determinants of commercial banks performance in a particular country. maghyerech and shammout (2004), for instance, study the determinants of commercial banks’ performance in Jordan during the period 1990–2000. They find a positive and significant relationship between size, capital adequacy, credit risk (net credit facilities/total assets), liquidity, growth rate in real GDP and bank profitability. The results also indicate a negative association between the return on equity and overhead ratio (general and administrative expenses/total assets), interest rate and banking development (credit to private sector/GDP). In other single-country studies, Ben Ben naceur and Goaied (2006) analyse the impact of banks’ characteristics, financial structure and macroeconomic indicators on banks’ net interest margins and profitability in the Tunisian banking industry for the period 1980-2000. They concluded that high net interest margins and profitability are associated positively with banks that hold a relatively high amount of capital and with large overheads, and negatively with the size. They find also that macroeconomic indicators (i.e. inflation, GDP), and market concentration ratio have no impact on banks’ interest margin and profitability. However, financial structure variables (stock market capitalization divided by total assets or GDP) do have a positive effect on the return on assets. A more recent study in this type of research is the investigation carried out by masood et al. (2009) to identify the determinants of saudi commercial banks’ profitability for the period 1999–2007. The results revealed that in case of calculating profitability in terms of ROE or ROA the most significant internal and external factors affecting saudi banks are capital adequacy ratio, earning assets to deposits ratio, operational efficiency, growth rate in GDP, and banking sector development. He finds also that variables to do with credit risk, inflation rate and interbank offered rate are insignificant and have a low effect on all indicators of profitability.


The second group of studies examines a panel of countries, and considers bank profitability as a function of internal and external determinants. Bashir and Hassan (2003) study the factors influencing the profitability of Islamic banks in eight middle Eastern countries for the period 1993–1998. They find that the higher leverage and large loans-to-asset ratios lead to higher profitability. This study also indicates a positive relationship between macroeconomic variables, stock market development and profitability of banks. staikouras and wood (2003) analyse the performance of a sample of banks operating in 13 European countries. The findings of this study revealed that loans-to0-assets ratio and the proportion of loan loss provisions are inversely related to banks’ return on assets, as well as that banks with the greater levels of equity are relatively more profitable. on the other hand, macroeconomic indicators (variability of interest rate, growth of GDP) had a negative impact on profitability. recently, using a linear model, Kosmidou and Pasiouras (2007) examine how a bank’s specific characteristics and the overall banking environment affect the profitability of commercial domestic and foreign banks operating in the 15 EU countries over the period 1995–2001. In brief, four important results should be emphasized. first, the capital strength (equity to total assets) and the efficiency in expenses management (cost to income) are the main determinants of profitability measured by ROAA. second, the ratio net loans to customer and short-term funding is statistically significant and positively related to the profitability of domestic banks, indicating a negative relationship between bank profitability and the level of liquid assets held by the bank. In the case of foreign banks, this ratio is also significant but has a negative sign, indicating a positive relationship between liquidity and banks’ profits. Third, the authors find no evidence to support the structure–conduct–performance (SCP) hypothesis. finally, the results indicated that macroeconomic conditions (inflation, growth of GDP) and financial market structure (stock market capitalization to total assets or to GDP, total assets to GDP) are statistically significant and related to both domestic and foreign banks profitability.

III. overview of the Gcc economies and Banking sector

3.1. economic development and growth in the GccThe Gcc economies share a number of common features. These countries are characterized by large oil-producing sectors, dependency on oil exports, stable currencies and stable price levels (Al-muharrumi et al. 2006).


table 1: Aggregate economic Indicators of the Gcc countries (2006)

countryPopulation

(Million)

nominal GDP

(million $)

Average inflation

(%)

Money supply

(M2)(million

$)

nominal GDP Per

capita ($)

current Account Balance

(% of GDP)

Real GDP

growth (%)

BahrainKuwaitomanQatarsaudi A.UAE

0.749

3.483

2.546

0.838

23.697

4.229

15823

98717

35729

52722

345138

163293

2.23.13.211.82.39.3

10734

55062

11569

24357

143672

107419

21123

31014

14032

62914

14733

38613

13.35

43.71

12.1130.56

27.35

22.01

6.54

6.28

6.78

10.34

4.29

9.38

Total or Average

35.242 711425 5.4 352813 30405 27.2 7.27

Source: International monetary fund, Gcc central Bank, Arab monetary fund Database.

over the past decade, and especially since 2002, the Gcc economies have been in a relatively strong position and continue to benefit from the sustained rally in oil prices (oil revenues tripled between 2002 and 2005, rising from 25% of GDP to 38%), as well as from the healthy performance of the non-oil sector (8% growth between 2002 and 2005 in real terms). nominal GDP, Us $ 349 billion in 2002, has more than doubled to $711 billion in 2006 (Table 1). In real terms, economic growth averaged a solid 7.4%2 a year during the period 2002–2006 (7.27% in 2006). Positive real growth in 2006 was visible in every one of the six Gcc countries, although it ranged widely from 4.29% in saudi Arabia to 10.34% in Qatar. Inflation also has remained subdued during most of the period; however, the fall in the Us dollar and the heating-up of the Gcc economies in the later years have ignited inflationary pressures, especially in Qatar (11.8% in 2006) and in the UEA (9.3%). Impressive economic growth has also lifted the region’s per capita income despite strong population growth.3 Per capita GDP increased from $10939 in 2002 to $30405 in 2006, growing at a 15% average a year. Qatar with a per capita income equal at $62914 far exceeded the average. meanwhile, oman’s GDP per head was the lowest at $14032 in 2006.

The rapid expansion of the Gcc economies is accompanied by other positive economic indicators. These include record surpluses in national budgets and record current account surpluses. for example, the current account balance for the Gcc, which was $25 billion in 2002 or 7% of GDP, rose


more than eight times in 2006 to reach $204 billion or 29% of the collective GDP. moreover, a large part of the oil windfall has been used to repay public debt. Indeed, the combined public debt of Gcc countries dropped from 64% to 18% of GDP between 2002 and 2006. saudi Arabia saw the largest decline, having paid down Us$85 billion in debts. on another positive note, the oil windfall and growth in government spending4 have built significant momentum in the business sector. Unlike previous oil booms, this one has been accompanied by soaring private investment. Indeed, the private sector has invested some $120 billion since 2003 in about 500 projects, and at least three times more is in the pipeline.5 The financial services, transport and storage, communication, construction and manufacturing sectors have all recorded double-digit growth since 2003, having benefited from the bulk of the private investment. finally, the present oil boom appears to be more sustained and considerably better managed that the first one in the 1970s and early 1980s: less money is wasted, projects are more targeted, and more reserves are built up and managed in more sophisticated and diversified ways (Hertog, 2007). All this augurs well for stable and sustained economic expansion, improvements in public services and the systematic removal of infrastructural bottlenecks.

3.2. the Gcc banking sectorThe Gcc banking industry has several futures that make it unique and different from other regions (Al-maharrami et al. 2006; olson and Zoubi, 2008): first, the sector is largely dependent on oil sector activities and protected from foreign competition. second, the banking industry’s main lending activities are concentrated in construction, real state and consumer loans. Third, the public sector continues to have a prominent role in the banking sector of the Gcc countries. fourth, Gcc banks are still small compared to the big international banks, the capital of all 50 Gcc banks ($31.5 billion) is considerably less than that of one bank in some countries (for example, the Hong Kong shanghai Banking corporation, whose capital is equal at $35 billion).

Both conventional financial institutions and Islamic banks have been expanding rapidly in the Gcc in recent years. several recent articles (e.g. Islam, 2003; Essayyad and madani, 2003) showed that commercial banks are well capitalized and have adopted modern banking services. most banks are characterized by satisfactory asset quality, capital adequacy and a high level of profitability.


Table 2 shows that the total assets of the 79 Gcc conventional and Islamic banks increased from $310 billion in 2001 to $651 billion in 2006. This represents more than 97% of total Gcc GDP. This ratio varies from 146% in Bahrain to as low as 33% in oman. The low assets-to-GDP ratio in a number of Gcc countries6 can be attributed to the existence of an informal economy that does not have access to formal financing, reflecting a pattern commonly seen in developing countries. meanwhile, deposits at Gcc banks amounted to more than $400 billion in 2006, the equivalent of 56.3% of the combined GDP of the six member countries. This ratio varies widely among Gcc countries, from as high as 79% of GDP in the UAE to as low as 34% of GDP in oman. likewise, the ratio loans to GDP is still low in the Gcc countries (equal to at 59% of GDP). oman has the lowest ratio (33%), while Bahrain has the highest, with its loans to GDP ratio reaching 81% in 2006. The low loans to GDP and deposits to GDP ratios indicate ample room for Gcc banking sector growth.

table 2: Gcc Banking Market size and Performance (2006)

country BanksAssets(B$)

Assetsto

GDP(%)

Loans(B$)

Loansto

GDP(%)

Deposits(B$)

Depositsto GDP

(%)

Roe(%)

RoA(%)

BahrainKuwaitomanQatarsaudi A.UAe

25

9

5

8

11

21

23092

93346

18724

52055

229623

234216

146

94.532.798.766.4144

12744

63346

11697

31162

169353

129111

80.564.232.759.149.179.1

12002

57760

12014

32775

157669

128287

75.858.533.662.245.778.6

19.221.318.2

21

30.118.6

1.62.92.52.93.92.4

total or average

79 651056 97.05 417413 60.78 400507 59.06 21.4 2.7

Source: Gcc central Bank, Arab monetary fund Database, Institute of Banking studies, Kuwait.

In terms of market share, the assets of the UAE amounted to $234 billion in 2006, representing 36% of total Gulf banks’ assets, followed by saudi banks with about $230 billion in assets, or 35% of total assets of local Gcc banks. similarly, saudi banks attracted $157 billion in deposits, the equivalent of about 40% of total deposits in Gulf banks, while the UAE and Kuwait were in second and third place with 32% and 14.5%, respectively. The smallest banking market among the Gcc countries is the omani banking market; its size amounted to $18.7 billion and $12 billion in term of assets and deposits, respectively.


Banking profitability can be looked at through ROE and ROA. As shown in Table 2, saudi Arabia, Qatar, Kuwait have relatively more profitable banking sectors. return on assets (ROA) of Gcc banks averaged 2.7% in 2006, with saudi banks significantly higher at 3.9%, indicating higher profitability relative to other Gulf banks. on the other hand, return on equity (ROE) varied widely, with that for saudi banks averaging at 30.1%. But overall, all Gcc banking sectors performed better than the standard averages of 10% ROE and 1% ROA.

finally, the Gcc banking sector was a main beneficiary of the very favourable economic environment as balance sheets expanded solidly and enhanced profitability. nevertheless, despite this robust growth commercial banking penetration rates are still generally low in the Gcc. Additionally, the size of Gcc banking is relatively slow and eventually these banks will need to grow externally to take competitors on or risk becoming easy targets.

IV. Data and empirical Methodology

4.1. DataThe data for this study comprise commercial banks (conventional and Islamic) in Bahrain, Kuwait, oman, Qatar, saudi Arabia and the United Arab Emirates. Deposit-taking companies, trust banks, finance companies and saving institutions are excluded. commercial banks’ financial statement data for institutions operating in six Gcc countries are sourced from the Bankscope Database of Bureau van Dijk’s company.

our sample is a balanced panel dataset of 66 commercial banks (48 conventional and 18 Islamic) observed over the period 1999–2006 consisting of 528 observations. There are 384 observations for conventional banks and 144 observations for Islamic banks. Table 3 presents the number of conventional and Islamic banks by country.

table 3: Banks in sample by country and type

countryconventional

BanksIslamic Banks

total number of banks

BahrainKuwaitomanQatarsaudi ArabiaUAe

7

6

5

6

9

15

6

4

-2

1

5

13

10

5

8

10

20

total 48 18 66


This study has used data from Bankscope because the financial and accounting information of banks is presented in standardized formats, after adjustments for differences in accounting and reporting standards. Additionally, the central banks in each country have required all banks (conventional or Islamic) to follow international accounting standards (IAs) in preparing financial statements. Therefore, comparing data across these countries should not cause any particular problem.

The macro and market-specific data were collected from annual reports published by central banks in each Gcc country and from other sources such as International monetary fund (Imf) and Arab monetary fund (Amf).

4.2. Determinants and variablesTable 4 provides a description of the variables used in this research, and also indicates their likely impact on commercial bank profits. The profitability variable is represented by the return on average assets (roAA). This ratio is computed by dividing the net profits over average total assets. It reflects the ability of a bank’s management to generate profits from the bank’s assets. Average assets are used in order to capture any differences that occurred in assets during the fiscal year.

4.2.1. Bank characteristics as profitability determinantsThe internal bank-specific characteristics that we include in our model represent information about capital adequacy, liquidity, asset quality (credit risk), financial risk, operational efficiency and size.

Capital adequacy: we use the ratio of equity to assets (EQA) to proxy the capital adequacy variable. Banks with high capital ratios would be considered relatively safer in the event of loss or liquidation, and would normally have lower needs for external funding and therefore higher profitability. several studies (Bourke, 1989; Berger, 1995; Kosmidou and Pasiouras, 2007) found a positive and strongly significant relationship between bank profitability and capitalization in many countries.

Liquidity: The ratio of net loans to deposits and short-term funding is used to measure the relationship between liquidity management and performance. It also indicates the risk of not having sufficient reserve of cash to cope with withdrawal of deposits. In order to hedge against liquidity risk, banks often hold liquid assets to meet advice shocks. Hence, the higher the value of the ratio, the less liquidity the bank has, and the higher will


be the profitability because liquid assets are usually associated with lower rates of return. consistently with this argument, molyneux and Thornton (1992), among others, found a weak inverse relationship, whereas Bourke (1989) found a significant positive association between liquidity and bank profitability. maghyerech and shammout (2004) explain the conflicting findings by a different elasticity of demand for loans in two samples.

Credit risk: to proxy this variable, we use the loan less loss provisions to total assets (NLA)7. Bank loans are the main source of revenues, but it also considered a largest source of credit risk. Theory suggests that increased exposure to credit risk is normally associated with decreased profitability and, if borrowers are able to repay debt and interests, we can say from the evidence that the higher this ratio (NLA) is, the higher the profitability of banks. Dermirguc-Kunt and Huizinga (1999) and others recently (Bashir and Hassan, 2003; maghyerech and shammout, 2004) found a strong positive relationship between the ratio of loans to total assets and bank profitability.

Financial risk: In the absence of guaranteed returns on deposits, Islamic banks undertake risky operations in order to be able to generate comparable returns to their customers. In this study, we use the ratio of total liabilities to total assets (LTA) as a proxy for this risk. LTA is also an indicator of lower capital or greater leverage. for Islamic banks, we expect a positive relationship between roAA and this ratio. However, in the absence of deposit insurance, high risk-taking will expose the bank to the risk of insolvency. Therefore the indicator (LTA) may have a negative impact on bank profitability. Bashir and Hassan (2003) have found a strong positive association between the ratio of total liabilities to total assets and profitability is measured by the ratio of before tax profit to total assets.

Operational efficiency: this variable is equal to total operating expenses minus provisions for credit losses divided by total operating income (coI8). It reflects the bank management’s ability to control operating expenses. The smaller this ratio, the greater the operational efficiency. Hence, the cost-to-income ratio is expected to be negatively related to profitability. several earlier studies (Pasiouras and Kosmidou, 2007; Ben naceur and Kandil, 2008; masood et al. 2009) confirmed this finding.


table 4: Description of Variables

Variables notation Descriptionexpected

effect

Dependent

Profitability ROAA The return on average total assets of the bank

Independent

Bank-specific (internal factors)

capital Adequacy

EQAEquity/total Assets. High ratios are assumed to be indicators of low financial capital leverage and hence low risk.

+

liquidity ratio

LQRloans/Deposits and short-term funding. The higher this ratio the less liquid the bank will be.

+

credit risk NLAnet loans/Total Assets. The higher this ratio the less risk assumed by bank. +

financial riskLTA

Total liabilities/Total Assets. The higher this ratio, the higher bank profitability. +

operational Efficiency

COI

cost/Income. This ratio provides information on the efficiency of the management regarding expenses to the revenues it generates. Higher ratio indicates a less efficient management.

-

size TA log Total Assets +/-

macroeconomic (external factors)

Inflation rate INF(cPI

t-cPI

t-1)/cPI

t-1. To proxy this variable we

use the growth of the consumer Price Index :cPI

+/-

real Gross Domestic Product Growth

RGDP(rGDP

t-rGDP

t-1)/rGDP

t-1. GDP is a general

index of economic development +

Growth rate of money supply

M2(m2

t-m2

t-1)/m2

t-1. m2=current in circulation

+ Private demand deposits in local currency with banks + quasi-monetary deposits.

+

financial Industry

Banking sector Development

CPGDP

credit to private sector/GDP. This variable is more than a simple measure of banking sector size, it also used to measure the importance of bank financing in the economy.

+

financial market Development

SMGDP

stock market capitalization/GDP. This ratio measures the overall level of development of the market and its importance in financing economy.

+

concentration CONC

Assets of the three largest banks/total Assets. The higher the concentration ratio, the more monopoly power there is in the banking system

?


Size: in order to capture possible non-linear relationship between size and profitability (Boyd and runkle, 1993), we use the logarithm bank assets (TA) as a proxy for bank size. Generally, the bigger the size of the bank the higher the profitability. The reason is that large size may result in economies of scale that will reduce the cost of gathering and processing information, or in economies of scope that result in greater loan product diversification and accessibility to capital markets which are not available to small banks (smirlock, 1985). However, for banks that become extremely large, the effect of size could be negative due to bureaucratic and other reasons. Indeed, some studies (Pasiouras and Kosmidou, 2007; Ben naceur and Goaid, 2006) found diseconomies for larger banks.

4.2.2. Macroeconomic profitability determinantsTo isolate the effect of bank characteristics on profitability, three macroeconomic variables are used: inflation rate, growth rate in real GDP and growth rate of domestic liquidity.

Inflation rate: we use the percentage change in the consumer price index (CPI) to proxy this variable. The impact of inflation rate on bank profitability depends on whether the inflation is anticipated. Perry (1992) argued that, if the inflation is anticipated, the banks can appropriately adjust interest rates in order to increase their revenues faster than their costs and, consequently, the inflation may have a positive impact on profitability. most studies (Bourke, 1989; molyneux and Thornton, 1992; Athanasoglou et al. 2008) reached similar results. However, if the inflation is not anticipated, the banks may be slow in adjusting their interest rates. This adversely affects bank performance.

Growth rate in real GDP: this variable is expected to have a positive impact on bank profitability. several studies (Islam, 1995; Allen and nadikumana, 1998; fritzer, 2004) showed that there is a systematic relationship between financial development and economic growth.

Growth rate of money supply: money supply (M2) consists of money in circulation (currency, notes and coins, issued by central bank minus currency with the banks) plus monetary deposits in local currency at commercial banks plus quasi-monetary deposits. like RGDP, this indicator (M2) is expected to have a positive effect on performance.

4.2.3. Financial industry profitability determinantsIn addition to macroeconomic variables, the performance of banks is related to the relative development of the banking industry and the stock market. we


consider three external determinants: Banking sector (CPGDP), financial market Development (SMGDP) and Bank concentration (CONC).

Banking sector development: CPGDP is the ratio of the value of credits by banks to the private sector divided by GDP. This variable is used as a proxy for the banking sector size, and is intended to measure the importance of bank financing in the economy. CPGDP is expected to impact performance positively (maghyerech and shammout, 2004; masood et al. 2009).

Financial market development: we use the ratio of stock market capitalization to GDP as a proxy for financial market development (SMGDP). It also indicates the importance of the stock market in financing the economy. several studies concerned conventional (Ben naceur and Goaid, 2003; Kosmidou and Pasiouras, 2007) or Islamic banks (Bashir and Hassan, 2003) found this variable to be positively related to bank performance.

Bank concentration: the two main measures of market concentration that have been proposed in the literature are the concentration ratio (CRk) and the Herfindahl-Hirschman Index (HHI). we use the CRk, which is calculated by dividing the total of the three largest banks in the market with the total assets of all commercial banks in the country. The relation between banking market structure and bank performance can go either positive or negative. starting with the positive impact that concentration can have on performance, the relative market power (RMP) hypothesis suggests that only banks with large market shares and well differentiated products can exercise market power and earn non-competitive profits (Berger, 1995). Indeed, market power allows banks to charge higher loan rates and offer savers lower deposit rate thus increasing the net interest rate margin (Goddard et al. 2004). likewise, the X-efficiency hypothesis is based on the view that a highly concentrated market may result from increased managerial and scale efficiency. on the other hand, a highly concentrated market can have a negative impact on bank profitability. williams (2003) examined the Australian market and found that concentration reduces profits of the foreign entrants and acts as an effective barrier to entry.

4.3. Model formulationTo identify the internal and external factors that affect the profitability of banks in Gcc countries during the period 1999-2006, we adapt the following linear model.

ROAAi,t

= α + β1 X

i,t + β

2Z

t + ε

i,t (1)


where ROAAi,t

is the return on average assets for bank i in year t, α is a constant, X

i,t represents the vector of characteristics of bank i in year t,

Zt represents the external factors, β

1 and β

2 are the vectors of regression

coefficients, and εi,t

= ui,t

+ vi is the disturbance term.

To estimate this model, we use the fixed effect model (FEM) and random effect model (REM). Using fixed effect regression, the bank specific effect (v

i) is taken to be constant over time and the functional form of one-

way panel data model is as follows:

ROAAi,t

= (α + vi ) + β

1 X

i,t + β

2Z

t + u

i,t (2)

where ui,t

~ IID (0, σ2u); IID: indicates that errors are independent identically distributed.

If vi is considered as an error term, we use the random effect model, then the

form of regression model is:

ROAAi,t

= α + β1 X

i,t + β

2Z

t + u

i,t + v

i (3)

where ui,t

~ IID (0, σ2u ) and vi ~ IID (0, σ2v ).

FEM is estimated using the within fixed effect, whereas REM is estimated using the feasible generalized least squares (GLS). The fixed effect model is tested by F test, while random effect is examined by the lagrange multiplier (LM) test. If the null hypothesis of heteroscedastic residual variance is not rejected, the pooled ordinary least square (OLS) regression is favoured. In order to find which of these models (FEM, REM) is the most appropriate, the Hausman specification test (H) is conducted.

V. empirical Results

5.1. Descriptive statisticsBefore we analyse factors that influence banks’ profitability, it is useful to comment on some preliminary features of our data. Table 5 presents descriptive statistics for the profitability measure (ROAA) and the variables that describe internal and external factors used in our model.


table 5: Descriptive statistics

Variable name Mean Median Minimum Maximum std.Dev.

roAA 2.84 2.30 -11.88 35.10 3.13

EQA 19.67 13.69 2.95 100.00 17.88

lQr 75.00 68.99 4.37 936.94 58.18

coI 42.07 39.08 9.77 370.00 21.53

nlA 52.34 53.22 0.00 89.89 18.63

lTA 80.92 86.35 3.02 97.04 15.97

Inf 2.26 1.80 -1.28 11.83 2.77

rGDP 6.12 6.06 -1.60 17.30 3.47

m2 13.10 10.53 0.00 43.30 8.78

cPGDP 35.96 33.43 3.44 59.13 10.60

smGDP 93.24 89.70 22.40 206.10 45.72

conc 57.61 49.96 31.85 89.73 18.73

The summary statistics show, for example, that the return on average assets is relatively high (with mean and median of 2.84% and 2.30%, respectively). likewise, the mean of capital adequacy ratio is large and varies greatly across banks (min =2.95%, max = 100%). The liquidity ratio is also very high with mean 75% and median 69%. on the other hand, Table 5 reveals that the mean of macroeconomic variables in the Gcc countries such as RGDP and growth rate of money supply (M2) are very high, equal to 6.12% and 13.1%, respectively. This indicates that the Gcc economies are in a relatively strong position as compared to ten years ago and collectively have shown growth rates much above the world average. The inflation rate during the period 1999-2006 is low (with mean 2.26% and median 1.8%); however, in 2007 the mean of this indicator in Gcc countries rose to 7%. more importantly, we can see from Table 5 that the average of private credit to GDP ratio (36%) is still far below the comparable level which exceeds 100% for high-income countries. This means that the banking sector in Gulf countries has ample room for growth. The ratio of concentration is relatively high (with mean 57.6% and median 50%) and differs widely across the banking sector of the Gcc countries (min = 32%, max = 89.7%). Based on the two measures of bank concentration (i.e. CRk and HHI), Bolbol and Al Karasneh (2006) show that the banking market in the Gcc countries can be viewed as ranging from moderately to highly concentrated, with Qatar exhibiting the highest concentrated market and UAE the lowest.


5.2. Regressions resultsTo estimate the panel regression model (equation 1), we used three alternative models: Pooled ordinary least square, fixed effects model and random effects model. Three tests are applied to choose between these methods. firstly the F-test shows that individual effects are present, since the relevant f statistic is significant at the 1% level (F

(65, 450) = 7.38), thus we choose the

fixed effects model. secondly, for the random effects model and in order to investigate whether there is evidence of heteroscedasticity in the residual variance, the Breusch-Pagan lagrange multiplier (LM) is calculated. with the large chi-squared (LM statistic = 456.22 with p < 0.000), we reject the null hypothesis in favour of the random effects model. finally as indicated by the Hausman test (H= 35.14 with a p-value = 0.0004), the difference in coefficients between fixed effect and random effect is systematic, providing evidence in favour of a fixed effects model.

Table 6 summarizes the empirical results of the estimation of model 2 (within fixed effect) using ROAA as the profitability variable. The first column presents the results of all banks in our data, both conventional and Islamic. columns two and three report the results for conventional and Islamic banks separately.

The capital adequacy variable (EQA) is highly significant and positively related to ROAA whether we look at conventional or Islamic banks. This result is consistent with previous studies (Berger, 1995; Dermirguc-Kunt and Huizingua, 1999; Bashir and Hassan, 2003; Kosmidou and Pasiouras, 2007; Ben naceur and Kandil, 2008) providing support to the argument that banks with a sound capital position are able to pursue business opportunities more effectively and can charge more for loans and pay less on deposits because they face lower bankruptcy risks. As expected, the coefficient of the cost to income ratio is negative in all cases. This finding shows that the cost decisions of bank management are instrumental in influencing bank performance. Indeed, several studies (maghyerech and shammout, 2004; Kosmidou and Pasiouras, 2007; masood et al. 2008; Athanasoglou et al. 2008) indicate a negative relationship between operational efficiency measured by the overhead ratio or cost to income ratio and banks profits. However, Ben naceur and Goaid (2003), in the case of Tunisian banks, found a positive association between the return on asset and overhead ratio. The result means that a more motivated (well-paid) staff contributes to the profitability of the banking industry as overhead is mainly composed of wages.


table 6: Regression Results (Fixed effect Model)

Variables All banksconventional banks

Islamic banks

EQA

lQr

nlA

lTA

coI

TA

Inf

rGDP

m2

cPGDP

smGDP

conc

Adjusted r2

f valuelmHausman testnb. observations

0.064

(6.449)*0.001

(0.368)0.017

(1.704)***0.352

(5.316)*-0.064

(-8.456)*0.216

(2.104)**0.023

(1.525)0.083

(2.218)**0.020

(3.182)*0.050

(0.424)0. 783

(2.166)**0.217

(2.563)**0.509

46.679

456.22

35.14528

0.049

(5.076)*-0.005

(-1.002)-0.015

(-1.958)**0.023

(1.282)-0.046

(-8.535)*-0.066

(-1.315)-0.046

(-0.160)0.018

(2.361)**0.038

(2.358)**0.011

(1.248)0.481

(2.233)**0.161

(2.927)*0.653

61.097

320.36

29.67

384

0.054

(2.701)*0.049

(1.953)**0.044

(1.862)***0.414

(4.678)*-0.076

(-5.144)*-0.439

(-1.491)0.031

(1.035)0.012

(1.982)**0.029

(2.200)**0.009

(0.684)0.021

(1.737)***-

0.413

9.412

185.54

23.15144

Notes: t-statistics are between parentheses; ‘*’; ‘**’; and ‘***’ indicate coefficient is significant at the 1%, 5%, and 10% levels, respectively.

The impact of the ratio net loans to customer and short term funding (lQr) on roAA is significant and positive only for Islamic banks. The result indicates a negative relationship between bank profitability and the level of liquid assets held by the bank. According to certain studies (chong and liu, 2008; olson and Zoubi, 2008) Islamic banks are riskier than conventional banks. consequently, they may hold more cash relative to assets or deposits,


thus the liquidity surplus affects bank profitability negatively because of the opportunity cost of the idle money.

referring to the credit risk, the results are mixed. The ratio net loans to total assets is statistically significant and positively related to the profitability of banks. This is consistent with previous studies (e.g. Bashir and Hassan, 2003; Ben naceur and Goaid, 2003). In the case of conventional banks – and contrary to our expectations – the variable (NLA) is also significant, yet has a negative sign. This result may be explained by the fact that conventional banks maintain higher reserves for loan losses, contrary to Islamic products (for example, ijarah and various Islamic lease back schemes) which may involve less risk than conventional loans; so less reserves are needed for bad loans. The financial risk variable (LTA) has a positive and significant effect on return on average assets for all banks and especially for Islamic banks. This result reveals the importance of leverage in the practice of Islamic banks and also indicates that Islamic banks undertake more risks than conventional banks. In fact, Islamic banks generally use deposits as a type of leverage to achieve higher profitability, but this type of leverage means the risk is also shared with depositors. This is line with olson and Zoubi (2008) who found that the equity multiplier (Asset/Equity) is larger for Islamic than for conventional banks.

In Table 6, the size variable (TA) is positive and significant for all banks. This finding is consistent with previous studies (smirlock, 1985; Genay, 1999; maghyerech and shammout, 2004). However, if we examine conventional and Islamic banks separately, the effect of bank size on profitability is negative and unimportant. This suggests mainly that if bank size exceeds a certain value, its profitability tends to be lower (vander vennet, 1998). Indeed, Kosmidou and Pasiouras (2007), among others, found a negative association between size and bank’s profitability for both domestic and foreign banks.

Turning to the macroeconomic control variables, Table 6 reveals that the growth rate of money supply (M2) and of real gross domestic product (RGDP) are statistically significant and positively related to both conventional and Islamic banks ROAA. similar results, which support the argument of a positive relationship between banks’ performance and economic growth, were obtained in other studies in the European market (Kosmidou and Pasiouras, 2007) and in middle Eastern countries (Bashir and Hassan, 2003, masood et al. 2009). Table 6 also shows that inflation rate appears to have an insignificant impact on banks’ profitability. This


is because inflation during the period 2002–2006 was largely moderate in the Gcc countries; this is also probably due to the high interest margins that banks earn. These results are in conformity with studies that examined single countries in the middle East (e.g. maghyerech and shammout, 2004; masood et al. 2009).

referring to financial structure variables, we see that the stock market capitalization to GDP ratio (SMGDP) and concentration indicator (CONC) have a significant and positive effect on returns on average assets. This finding about SMGDP suggests that there are complementarities between bank and equity market in Gcc countries. It also indicates that a larger stock market relative to the banking sector increases bank profitability. on the other hand, the relationship between the concentration indicator and ROAA is significant at the 1% level for conventional banks. This confirms that market structure (SCP hypothesis) has a positive impact on growth in the Gcc banking sector. This positive effect is mostly related to the efficiency of more bank lending due to cost advantages as banks reap economies of scale in the production of banking services. Indeed, according to the study of Al-muharrami et al. (2006), Gcc banks, especially in Qatar, Bahrain, and oman which are operating under conditions of monopolistic competition, earn monopoly profits by working with a wider margin of intermediation.

finally, the empirical results show that the banking development variable (CPGDP) affects bank profitability positively, but this effect is relatively insignificant for both conventional and Islamic banks. Bashir and Hassan (2003), who examined Islamic banks in middle Eastern countries found a strong association between ratio of total assets divided by GDP and the ratio of before tax profit to total assets. In contrast, some studies (Demirguc-Kunt and Huizingua, 1999; Kosmidou and Pasiouras, 2007) conclude that if the banking assets constitute a large portion of the GDP, the size of the banking sector will have a negative incidence on banks’ profitability.

VI. conclusionIn the context of liberalization, the financial landscapes in Gcc countries such as Kuwait, Qatar, saudi Arabia, and the UAE have undergone significant changes (new licenses to Islamic and foreign banks, new financial free zones in Qatar, Dubai, and ras Al Kaimah) that posed great challenges to the banks. These changes increased local competition and could have some impact on banks’ performance.


In this paper, we adapt linear models to investigate the determinants of banks’ profitability for conventional and Islamic commercial banks operating in Gcc countries between 1999 and 2006. The factors that may affect profitability, measured by the return on average assets, involve bank-specific characteristics, macroeconomic variables, and financial industry indicators.

The empirical results indicate that the capital adequacy ratio is positively related to ROAA for both Islamic and conventional banks. likewise, the coefficient of operational efficiency is also significant but has a negative impact on performance in both cases. The relation between liquidity and profitability is negative only for Islamic banks. These institutions are likely to be more liquid than conventional banks. The net loans to assets ratio has a significant impact on ROAA in all cases but with opposite signs for conventional and Islamic banks. The difference in the impact of credit risk on profitability can be explained by the value of provisions for possible loan losses which is much higher in conventional than in Islamic banks. The positive and significant effect of the financial risk variable in the case of Islamic banks reveals the importance of leverage in the practice of Islamic banks. for all banks, the size variable has a positive effect on profitability. This is probably due to economies of scale and is consistent with previous studies. The impact of macroeconomic control variables, such as GDP and money supply, on profitability was significant and positive in all cases. This finding provides additional support to the strong relationship between economic growth and banking sector performance. As for the effect of inflation rate, the study showed that this variable is insignificant in explaining profitability. Turning to financial structure indicators and their effect on bank’s profitability, we found that the stock market capitalization to GDP ratio and concentration were positively associated to ROAA. These results indicate, on the one hand, that there are complementarities between bank and equity markets in Gcc countries; on the other hand, the market structure has a positive impact on growth in the banking sector. However, the market structure of the Gcc banking industry is widely different in each of the six countries. Indeed, Al-muharrami et al. (2006) found that Kuwait, saudi Arabia, and UAE have moderately concentrated markets and are moving to less concentrated positions. In contrast, banks in Bahrain, Qatar, and oman operate under conditions of monopolistic competition. As far as the banking development indicator is concerned, its effect on profitability is insignificant. This means that the contribution of commercial banking in


financing the economy is still low in the Gcc countries. The fact that the ratio is low (credit to private sector to GDP) shows the existence of ample room for Gcc banking sector growth.

overall, these empirical results provide evidence that the profitability of Gcc banks is shaped by bank-specific characteristics, macroeconomic variables and financial industry. Yet, some indicators such as inflation and banking development do not seem to affect performance.

Based on the results of this study, it is useful to draw several recommendations and proposals. first, Gcc countries are expected to open up their banking sector to foreign competition. Hence, conventional and Islamic banks need to position themselves and align activities with those in developed countries in order to ensure their continued profitability. This could be accomplished by building large national champions, which can form the nucleus of further consolidation on the regional level. for this reason, it might be better first to liberalize the financial sector between Gcc countries to foster cross-border financial cooperation, and then go for total liberalization of this region. second, with a very favourable economic environment in the Gulf region, several opportunities exist for the banking sector not only in lending but in raising finance through alternative channels such as real estate funds. moreover, conventional and Islamic banks can play an important role in financing large scale investments across the Gcc countries which are estimated at Us$1 trillion between 2006 and 2010. Third, according to many studies, Islamic banks undertake more risk than conventional banks because they deal in new and unfamiliar forms of finance. Therefore, as suggested by olson and Zoubi (2008), they may need to be more careful in monitoring and regulators must impose higher capital requirements on this type of banks.

The limitations of our study are the following. we did not include some variables in our model such as the ownership status of banks and the business cycle that may affect banks’ profitability. furthermore, the time period of analysis is relatively short (8 years), and we estimate that the results may be different if a larger time frame is used, especially including the years 2007 and 2008, which witnessed certain important events (rise in inflation, stock market bubble…). finally, it would be interesting to widen the sample of study by adding other countries. for example, we can examine the factors influencing banks’ profitability in the middle Eastern and north African (mEnA) countries or, more largely, in the whole Arab region.


Notes

1. Gcc Banking may, 2007: Institute of Banking studies, Kuwait2. Gcc Banking may, 2007: Institute of Banking studies, Kuwait.3. Gcc population growth has averaged 3.4% per annum, between 2002 and 2006,

among the highest rates in the world.4. more than half of the projects ($200 billion) launched since 2003 have been sponsored

by governments (ministries, municipalities, and other government-owned entities such as national oil companies).

5. Gcc Banking may, 2007: Institute of Banking studies, Kuwait.6. In the euro zone the ratio of total assets to GDP is equal 189%.7. other ratios used to measure credit risk were loans/deposits, loan-loss provisions/

loans and provisions /assets.8. This variable can be measured by dividing the general and administrative expenses

over total assets.

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Documents

Factors Influencing the Profitability of Conventional and Islamic Commercial Banks in GCC Countries