Impact of Internal Factors on Islamic Banking

Impact of Internal Factors on Moslem Banking entryway to the SubjectBackground of the Subject superior general ObjectiveThe purpose of this airfield is to attempt how the essential reckons of the Moslem Banking happen uponed their execution before, during and after the financial crisis in the GCC in comparability to the ceremonious asserting in the selfsame(prenominal) argona.Research QuestionsThis written report aims to answer the following questionsHow did the financial crisis affect the bring inability of Moslem Banks in comparison to Conventional Banks?What atomic material body 18 the immanent factors ( money box specific characteristics) that influence the favourableness of Moslem argoting for completely(prenominal) grade from 2006 2009?Did these factors kick in the same tint on the lucrativeness of Moslem Banking before, during and after the financial crisis?Did these congenital factors influence the positivity of Moslem Banking in the same mann er as of the Conventional Banking?Need for the mootSignifi heapce of the watchAssumptions of the StudyLimitations of the StudyAlthough we set up non neglect the importance of the outdoor(a) factors on the advantageousness of Moslem Banking, they were non take on in this try. To understand the reason behind this decision, we need to go through the divergent guinea pigs of external factors and how they atomic number 18 classifiedMacroeconomic FactorsCountry regulating RulesBank code RulesThese factors were not include for the following reasonsSince we atomic number 18 examining the consummateance of 92 avers (27 Muslim Banks and 65 Conventional Banks) in 6 countries, the egress of countries use in the say is not significant enough to study the impact of GDP and s intumesceing accu reckonly on Bank lucrativeness especially when examining each year separatelyCountry Regulation Rules as per the IMF Database, although it differs reasonably for the selected countrie s, did not change all everywhere the result from 2006 to 2009. This message that for each shore, these factors remained constant.Data just about Bank Regulation Rules could not be obtained for GCC fixsDelimitation of the StudyThis study was delaminated to the Muslim and Conventional Banks in the GCC whose selective tuition could be obtained in the Bankscope infobase.Chapter 2 Literature ReviewOverview of Moslem Banking Moslem Baking has set up as an election to unoriginal liaison-based tilling. The first stirring of the Muslim Banking movement began in 1963 by Dr. Ahmed Alnajar in a delicate town in Egypt, called Mit Ghamar. Dr. Alnajar completed his education in Ger m either an(prenominal) and lay out that it had legion(predicate) miserliness edges operating on enkindle. He took the idea from a nest egg confide in Ger more and created his own picayune Moslem depone that was interest free.After Dr. Alnajars small bank prove successful, the establishment of early(a) Muslim banks followed. In 1971, the Nasser Social Bank was undercoated in Egypt with the objective of lending out money as a benignity on the priming of a realize and outlet sharing system and component part people in need. And in 1975, the idea of Moslem banking spread to different Islamic regions very much(prenominal) Dubai Islamic bank in coupled Arab Emi grade and The Islamic Development (IDB) Bank in Jeddah, Saudi-Arabian Arabia (Wilson, 1990).Even though Islamic Banking has b atomic number 18ly been round for thirty historic expi symmetryn and is still in an evolving stage, Islamic Banking is the fastest matuproportionn segment of the computer address markets in the Muslim countries. In 2009, pluss held by Islamic Banking banks rose by 28.6 sh ar to $822bn from $639bn in 2008, concord to The Bankers Top 500 Islamic Financial Institutions? survey while received banks posted yearbook summation offshoot of just 6.8 percent.Further much, GCC s tates accounted for $353.2bn or 42.9 percent of the global aggregate, while Iran remained the liberalst single(a) market for sharia-compliant pluss, chronicle for 35.6 percent of the kernel.Source Asian Banker Research, 2009Finally, Islamic banking ope balancens be not restrain to Islamic countries tho are spreading throughout the world. One reason is the growing trend toward transcending discipline boundaries, and unifying Muslims into a political and economic entity that could meet a significant impact on the recitation of world softwood (Abdel-Magid, 1981).Islamic Banking Rules and PrinciplesIslamic banking rules are according to the Islamic Shariah derived from the Quran and vaticinator Mohameds sayings. The trine main practices that are clearly prohibited in the Quran and the prophets sayings are, Riba ( have-to doe with), Gharar (Uncertainty), and Maysir (Betting).Prohibition of Riba or any predetermined or primed(p) rate in financial institutions is the mos t(prenominal) important factor in the Islamic principles pertaining to banking. As stated in the Quran Allah forbids riba?. Riba means an join on and under Shariah the term refers to the premium that must be paid by the borrower to the lender a dour with the principle step as a condition for the loan (Omar and Abdel, 1996).Gharar occurs when the purchaser does not agnise what has been bought and the marketer does not know what has been sold. In early(a) words, trading should be clear by stating in a arrest the be actual object(s) to be sold, with a price and date to eliminate confusion and irresolution among the buyers and the sellers.Maisir is considered in Islam as one form of injustice in the appropriation of others wealth. The act of gambling, slightly terms referred to betting on the occurrence of a future event, is prohibited and no reward accrues for the employment of expense of wealth that an soul may gain through means of gambling. Under this prohibition, any co ntract entered into, should be free from uncertainty, jeopardy and speculation. Contracting parties should have perfect knowledge of the counter values intended to be tackd as a result of their transactions. therefore, and according to Ahmed and Hassan (2007), the principles of Islamic banking and finance enshrined from al-Quran and Prophet Mohameds Sayings can be summed up as followsAny predetermined wages over and above the actual measuring rod of principal is prohibited.The lender must share in the profits or losses arising out of the initiative for which the money was lent. fashioning money from money is not acceptable in Islam.Gharar (deception) and Maisir (gambling) are as well prohibited. enthronizations should wholly support practices or products that are not forbidden or even discouraged by Islam.Islamic Banking ProductsIslamic Banking products have to be done according to Islamic rules and principles, based on profit and loss sharing as well as avoiding interest. a ccord to BNM statistics 2007, Al Bai Bithaman Ajil financing is the most common in Islamic Banking. thither are a lot of Islamic Banking products however in that respect are some famous Islamic products that go forth be discussed in this section.Al Bai Bithaman Ajil /BBAThis involves the credit sale of goods on a deferred payment stern. In BAA, the Islamic bank go away purchase certain assets on a deferred payment basis and and so sell the goods back to the node at an hold price including some bank or profit. The customer will make payment by installments over an hold period. A fixed rate BBA is a powerful hedging tool against interest evaluate (Rosly, 1999).MurabahahMurabahah is a contract of sale. The Islamic Bank acts as a middle man and purchases the goods requested by the customer. The bank will afterwards sell the goods to the customer in a sale and purchase commensurateness, whereby the lender re-sales to the borrower at a high(prenominal) price agreed on by twain parties. These are more than(prenominal)(prenominal) for short term financingMudharabahAccording to Kettel (2006), Mudharabah is a basic principle of profit and loss, where instead of lending money at a fixed rate afford, the banker forms a partnership with the borrower, thereby sharing in a ventures profit and loss. Mudharabah is an agreement betwixt the lender and entrepreneur, whereby the lender agrees to finance the project on a profit sharing basis according to a predetermined ratio agreed by both parties concerned. If there are any losses the lender will bear all the losses.MusharakahMusharakah means partnership whereby the Islamic institution provides the ceiling needed by the customer with the understanding that they both share the profit and loss according to a formula agreed before the business transaction is transacted. In Musharakah all partners are entitled to insert in the management of the investment but it is not compulsory. Musharakah can help in pro viding financing for large investments in modern economic activitiesAl IjarahIjarah means meaning to give something on a letting basis. In Ijarah, the bank acquires possession based on the promise and leases back to the customer for a accustomed period. The customer pays the rental but the self-command still remains with the bank or lender. As the will power remains with the lessor (bank), it continues to give the service for which it was rented. Under this contract, the lessor has the right to re-negotiate the quantum of the lease payment at every agreed interval to ensure rental remains in line with the market rates (Hume, 2004).WadiahWadiah is a organized religion contract and the bank provides gift (hibah) and various types of benefits to the customer. This is exactly like a convening received savings account.IstisnaIstisna allows one party buys the goods and the other party undertakes to manufacture them according to agreed specifications. Normally, Istisna is utilise to finance device and manufacturing projects.SalamSalam is defined as the forward purchase of specified goods with full forward payment. This contract is normally utilize for financing agricultural production. According to Hassan (2004), Salam based future contracts for agricultural commodities, supported by Islamic Banks, can help to overcome the agricultural financial problemsTable 2.1 lists the products of received banking and their correspondent products in Islamic Banking. flummox serviceCurrent DepositWadiah Wad Dhamana / Qard HasanSavings DepositWadiah Wad Dhamana / MudarabaGeneral Investment adhereMudarabaSpecial Investment depositMudarabaRetail / Consumer BankingHousing Property payBBA / Ijara wa Iktina / fall Musharaka make PurchaseIjara Thumma Al-BaiShare FinancingBBA / Mudaraba / MusharakaWorking detonating device FinancingMurabahah/ Bai Al-Einah/ Tawarruq creed plug-inBai Al-Einah/ TawarruqCharge teaseQard HasanCorporate Banking/ Trade FinanceProject FinancingM udaraba / Musharaka / BBA / Istisna / IjaraLetter of CreditMusharaka/ Wakala/ Murabaha act CapitalDiminishing Mudaraba/ MusharakaFinancing SyndicationMusharaka + Murabaha/ Istisna / IjaraRevolving FinancingBai Al-EinahShort-term Cash AdvanceBai Al-Einah/ TawarruqWorking Capital FinanceMurabaha/ Salam/ IstijrarLetter of CreditMurabahaLetter of GuaranteeKafala + UjrLeasingIjaraExport/ Import FinanceMusharaka/ Salam/ MurabahaWork-in-Progress, Construction FinanceIstisna charge DiscountingBai al-DaynUnderwriting, Advisory serviceUjrTreasury / Money Market Investment ProductsSell buy-back agreementsBai al-EinahIslamic BondsMudaraba / Mushraka + BBA / Istisna / IjaraGovernment Investment IssuesQard Hasan/ Salam/ Mudaraba another(prenominal) Products ServicesStock-Broking ServicesMurabaha/ Wakala/ Joala gunstocks Transfer (Domestic Foreign)Wakala/ JoalaSafe-Keeping Collection (Negotiable Instruments)Wakala/ JoalaFactoringWakala/ Joala/ Bai al-DaynAdministration of Property, Estates and WillsWakalaHiring of Strong BoxesAmana/ Wakala pick out Draft, Travellers ChequesUjr/ JoalaATM Service, Standing Instruction, TelebankingUjrSource Obaidullah, 2005Financial Crisis and the Islamic BankingPrevious LiteratureThe study of bank profitability is an important tool to evaluate bank operation by examining the different factors change bank profitability and using these factors for management planning and strategic analysis. In the last four decades, many studies have been conducted to study both bank profitability and the determinants of bank profitability either for particular coarse or for a panel of countries. These studies normally divide these factors into native factors and external factors. Internal factors represent the bank-specific characteristics such(prenominal) as bank coat, mobileity twist liabilitiesetc while external factors can be macroeconomic factors such as swelling and GDP growth or Country-specific regulations rules and practices.In the area of banking profitability, many studies have been conducted to ask the profitability of conventional banks while only few were conducted in the field of Islamic banking. In this chapter, we will review these studies for conventional banking first and then will focus on studies in the Islamic banking field. wherefore we will privacy the conceptual framework of this research.Conventional BankingDifferent studies have been conducted in the field of conventional banking profitability. Short (1979), Bourke (1989), Molyneux and Thornton (1992), Goddard, Molyneux, and Wilson (2004), Peters et al. (2004) are some of the researchers in the field.Short (1979) is one of the early scholars who analyse the descent in the midst of banking profit rates and concentration for sixty banks in Canada, Western Europe and Japan during the 1970s and he include fissiparous variables including governing self-control and concentration by using H index to valuate concentration. Results showed that the government ownership impact on profitability varied throughout the countries studied but show an overall prohibit blood. He in any case open evidence that testifyd higher concentration rates function to higher profit rates (Short, 1979).Bourke (1989) overly compared concentration to bank profitability but included other determinants. Bourke (1989) covered ninety banks in Australia, Europe, and North America amongst 1972 and 198 and examined different inherent and external factors internal factors such as staff expenses, detonator ratio, fluidnessity ratio, and loans to deposit ratio external factors such as regulation, size of economies of scale, competition, concentration, growth in market, interest rate, government ownership, and market power. His results show that increase in government ownership leads to light profitability in banking. He also constitute that concentration, interest rates, and money tot are prescribedly related to profitability along with capita l and reserves of natural assets as well as currency and bank deposits of perfect assets. Bourke adds that well capitalized banks enjoy cheaper access to sources of funds as they are less questioning than less capitalized banks (Bourke, 1989).Later, Molyneux and Thornton (1992) studied the determinants of European banks profitability. The paper examined eighteen counties in Europe amid 1986 and 1989. This paper replicated Bourkes (1989) work by using internal and external determinants of bank profitability. However, Molyneux and Thornton (1992) results showed that government ownership expresses a substantiative coefficient with return on capital (profitability) which contradicts with Bourkes findings. Other results were similar to Bourkes, showing that concentration, interest rate, and money summate were corroboratively related to bank profitability (Molyneux and Thornton, 1992).In one of the recent papers on bank profitability on European banks, Goddard, Molyneux, and Wils on (2004) shows similar findings to the paper by Molyneux and Thornton (1992). It investigates the determinants of profitability in six European countries and it covered 665 banks between 1992 and 1998. The study utilise cross-sectional and dynamic panel representatives. The variables employ in the reversal analysis were hard roe, the logarithmic of bestow assets, Off Balance Sheet (OBS) dividends, Capital to Asset Ratio (CAR). The results from both models were similar evidence reveals that there is a tyrannical affinity between size ( score assets) and profitability. Meanwhile, OBS appears to have a positive relationship with profitability for UK but neutral or negative for other European countries. Moreover, results also state that CAR has a positive relationship with profitability. Furthermore, the paper touched on ownership type by indicating that there is high competition in banking due to the fact that there is foreign bank involvement in domestic banks, and that profit ability is not linked to ownership (Goddard, Molyneux, and Wilson, 2004).Peters et al. (2004) studied the characteristics of banks in post-war Lebanon for the eld 1993 to 2000 and compared the results to a classify of banks from five other countries in the Middle East including UAE, KSA, Kuwait, Bahrain and Oman for the years 1995 through 1999. They utilise give-up the ghost on impartiality ( roe) step profitability and leverage and they employed fixation models that relate bank profitability ratios to various explanatory variables. This study tests the relationships between bank profitability and size, asset portfolio composition, off-balance sheet items, ownership by a foreign bank, and the ratio of employment to assets. The results show a crocked association between economic growth and bank profitability, whether measured by hard roe or ROA. They found that Lebanese banks are profitable, but not as profitable as a control group of banks from five other countries located i n the Middle East.Islamic BankingIn the area of Islamic Banking, Bashir (2000) assessed the executeance of Islamic banks in eight Middle Eastern countries. He analyzed important bank characteristics that affect the process of Islamic banks by controlling economic and financial organize measures. The paper studied cardinal Islamic banks from Bahrain, Egypt, Jordan, Kuwait, Qatar, Sudan, Turkey, and United Arab Emirates between 1993 and 1998. To examining profitability, the paper use Non Interest Margin (NIM), Before Tax wampum (BTP), father on Assets (ROA), and Return on faithfulness (ROE) as coiffureance indicators. There were also internal and external variables internal variables were bank size, leverage, loans, short-term funding, overhead, and ownership external variables included macroeconomic environment, regulation, and financial market. In general, results from the study aver previous findings and show that Islamic banks profitability is positively related to virtu e and loans. Consequently, if loans and equity are high, Islamic banks should be more profitable. If leverage is high and loan to assets is also large, Islamic banks will be more profitable. The results also indicate that favorable macro-economic conditions help profitability (Bashir, 2000).Hassoune (2002) examined Islamic bank profitability in an interest rate cycle. In his paper, compared ROE and ROA Volatility for both Islamic and conventional banks in three GCC region, Kuwait, Saudi Arabia, and Qatar. He states that since Islamic banking is based on profit and loss sharing, managements have to open sufficient returns for investors given that they are not willing accept no returns (Hassoune, 2002).Bashir and Hassan (2004) studied the determinants of Islamic banking profitability covers 43 Islamic Banks between 1994 and 2001 in 21 countries. Their figures show Islamic banks to have a advance capital asset ratio compared to commercial banks which means that Islamic banks are wel l capitalized. Also, their paper utilize internal and external banks characteristics to determine profitability as well as economic measures, financial structure variables, and country variables. They used, Net-non Interest Margin (NIM), which is non interest income to the bank such as, bank fees, service charges and foreign exchange to identify profitability. Other profitability indicators adopted were Before Tax Profit divided by total assets (BTP/TA), Return on Assets (ROA), and Return on Equity (ROE).Results obtained by Bashir and Hassan (2004), were similar to the Bashir (2000) results, which found a positive relationship between capital and profitability but a negative relationship between loans and profitability. Bashir and Hassan also found total assets to have a negative relationship with profitability which amazingly means that smaller banks are more profitable. In addition, during an economic boom, banks profitability seems to improve be pillow slip there are fewer nonp erforming loans. Inflation, on the other hand, does not have any effect on Islamic bank profitability. Finally, results also indicate that overhead expenses for Islamic banks have a positive relation with profitability which means if expenses increase, profitability also increases (Bashir and Hassan, 2004).Alkassim (2005) examined the determinants of profitability in the banking sector of the GCC countries and found that asset have a negative impact on profitability of conventional banks but have a positive impact on profitability of Islamic banks. They also discover that positive impact on profitability for conventional but have a negative impact for Islamic banking. Liu and Hung (2006) examined the relationship between service quality and long-term profitability of mainland Chinas banks and found a positive link between branch number and long-term profitability and also proved that ordinary salaries are detrimental to banks profit.Masood, Aktan and Chaudhary (2009) studied the c o-integration and causal relationship between Return on Equity and Return on Assets for 12 banks in KSA for the period between 1999- 2007. For their research, the used time series model of ADF unit-root test, Johansen co-integration test, Granger causality test and graphical comparison model. They found that there are stable long run relationships between the two variables and that it is only a one-direction cause-effect relationship between ROE and ROA. The results show that ROE is a granger cause to ROA but ROA is not a granger cause to ROE that is ROE can affect ROA input but ROA does not affect the ROE in the Saudi Arabian Banking sector.Conceptual FrameworkTheoretical framework is a basic conceptual structure organized around a theory. It defines the kinds of variables that are going to be used in the analysis. In this research, the speculative framework consists of seven-spot independent variables that represent four aspects of the Bank Characteristics. Theses aspects are th e Bank Size (Total Assets), Capital construction (Equity and conspicuous Equity), Liquidity (Loans and Liquid Assets) and Liabilities (Deposits and Overheads). Bank profitability is the dependent variable and two measures of bank profitability are used in this study, namely return on average equity (ROAE) and return on average assets (ROAA).Financial CrisisInternal Factors (Bank-Specific)Islamic Banking positivityH1 Bank SizeH2, H3 Capital StructureH4, H5 LiquiditiesH6, H7 LiabilitiesReturn on Average Assets (ROAA)Return on Average Equity (ROAE)In this section we amplify the possibleness to be examined in this research paper.Development of HypothesesThis paper attempts to test seven hypotheses. A hypothesis is a advance or assumption about the value of a population parameter. It consists either of a suggested explanation for a phenomenon or of a reasoned proposal suggesting a possible correlation between multiple phenomena. According to Becker (1995), hypothesis testing is the process of judging which of two contradictory statements is correct. surmisal 1 Profitability has a positive and significant relationship with the total assets (ASSETS).Total Assets of a company represents its valuables including both tangible assets such as equipments and properties along with its intangible assets such as goodwill and patent. For banks, total assets include loans which are the basis for bank operations either through interest or interest-free practices. Total assets is used as a tool to measure the bank size banks with higher total assets indicate big banks. Molyneux and el (2004) included total assets in their study and found a positive significant relationship between total assets and profitability. Therefore, total assets are judge to have positive relation with profitability which means that bigger banks are judge to be more profitable. Total assets are converted logarithmic to be more unchanging with the other ratios supposition 2 Profitability has a pos itive and significant relationship with equity to asset ratio (EQUITY).Total equity over total assets measures banks capital structure and adequate. It indicated bank ability to withstand losses and handle risk exposure with shareholders. Hassan and Bashir (2004) examined the relationship between EQUITY and bank profitability and found positive relationship. Therefore, EQUITY is included in this study and it is expected to have a positive relation with performance because well capitalized banks are less risky and more profitable (Bourke, 1989)Hypothesis 3 Profitability has a positive and significant relationship with tactual Equity to total liabilities ratio (TNGEQTY).Tangible Equity represents the subset of shareholders equity that is not common shares and not intangible asset. Tangible Equity became very popular after the financial crisis as a measure of bank viability since it indicates of how much ownership equity owners of common stock would receive in the event of a companys liquidation. Beltratti and Stulz (2009) examined tangible equity to liabilities in their study to examine why some banks perform better during the financial crisis and found positive and insignificant relationship between TNEQTY and bank profitability. Therefore, TNEQTY is included in this study and it is expected to have positive relationship since banks with better capital structure in since of more equity seems to perform better.Hypothesis 4 Profitability has a positive and significant relationship with the loans to assets ratio (LOANS).Total loans over total assets a runniness ratio used that indicates how much of bank assets are tied to loans. For banks, the higher LOANS ratio means less liquidity. Demirguc-Kunt and Huizinga, (1997) found positive relationship between LOANS and bank profitability. LOANS is included in this study and anticipated to have positive relationship with profitability. Furthermore, conventional banks rely on interest-based loans while Islamic banks r ely on profit and loss sharing interest-free lending. Therefore, this ratio is also used to compare the performance of interest-based loans and interest-free lending.Hypothesis 5 Profitability has a positive and significant relationship with the liquid assets to total assets ratio (LIQUID).Liquid assets include currency, deposit accounts, and negotiable instruments that can be converted considerably into cash. Liquid assets to total assets ratio is a liquidity ratio that measure how easily the banks assets can be converted into cash. Beltratti and Stulz (2009) found that LIQUID has positive and significant relation with profitability as banks with more liquid assets tend to perform better. Therefore, LIQUID is included in this study and expected to have positive relationship with profitability.Hypothesis 6 Profitability has a reverse and significant relationship with the deposits to assets ratio (DEPOSITS).Deposits to total ratio is another liquidity indicator but is considered a l iability since they measure the impact of liabilities on profitability. Bashir and Hassan (2004) examined deposits in their study and found a negative relationship with profitability. Therefore, we expect that DEPOSITS to have negative relationship with profitability.Hypothesis 7 Profitability has a positive and significant relationship with the overhead to assets ratio (OVERHEAD).Overhead cost represent all bank expenses excluding interest expenses as they are considered as operations expenses. Overhead over total assets is a liability ratio that measures the operation efficiency of the bank. Alkassim (2005) included OVERHEAD in his research and found positive relationship to profitability. Therefore, OVERHEAD is included in this study and expected to have positive relationship to profitability.Chapter 3 MethodsData tryFrom 2006 to 20082009CountryIslamic BanksConventional BanksIslamic BanksConventional BanksBahrain121455Saudi Arabia2917Qatar3524Kuwait41413Oman0603UAE61707Total2765 929The data used in this analysis were extracted from Bankscope data for all Islamic and Conventional Banks in the GCC for the period from 2006 to 2009. employ Bankscope has many advantages it has teaching for over 30,000 banks, plus the accounting nurture is presented in a alike(p) format. Therefore, the accounting information of Islamic Banking is adjusted to be comparable with accounting information of conventional banks.The data used for this study are from a pooled time-series cross-sectional data. The data are taken from various countries. Sample period for this study is from 2002 to 2007. Cross-sectional data provide information on variables for a given period of time. While time series data give information about variables over a number of periods of time.The data for internal variables are obtained from BankScope database which is compiled by International Bank Credit Analysis Limited (IBCA). Using BankScope has two advantages. Firstly, it has information for 11,000 bank s, accounting for about 90% of total assets in each country. Secondly, the accounting information at the bank level is presented in standardized formats, after adjustments for differences in accounting and reporting standards. The data for external variables are obtained from World Economic Outlook 2008 database, published by International Monetary Fund (IMF).A total of 60 Islamic banks from 18 countries were chosen in this study. The selected banks are those which are classified as Islamic bank in BankScope database. The Islamic banks have available data for at least(prenominal) one year between 2002 and 2007. This yielded an unbalanced panel data consisting of 260 observations. However, after eliminating cases with missing data, only one hundred fifty-five observations of balanced panel data are left.Variable DefinitionIndependent Variable Profitability MeasuresThere are many ratios that have been used by researchers to measure bank profitability but the two most frequently used ratios are the return on assets (ROA) and the return on equity (ROE) (Iqbal et al., 2005).Return on AssetsImpact of Internal Factors on Islamic BankingImpact of Internal Factors on Islamic BankingIntroduction to the SubjectBackground of the SubjectGeneral ObjectiveThe purpose of this study is to examine how the internal factors of the Islamic Banking affected their performance before, during and after the financial crisis in the GCC in comparison to the conventional banking in the same area.Research QuestionsThis study aims to answer the following questionsHow did the financial crisis affect the profitability of Islamic Banks in comparison to Conventional Banks?What are the internal factors (bank specific characteristics) that influence the profitability of Islamic banking for every year from 2006 2009?Did these factors have the same impact on the profitability of Islamic Banking before, during and after the financial crisis?Did these internal factors influence the profitability o f Islamic Banking in the same manner as of the Conventional Banking?Need for the StudySignificance of the StudyAssumptions of the StudyLimitations of the StudyAlthough we cannot neglect the importance of the external factors on the profitability of Islamic Banking, they were not included in this study. To understand the reason behind this decision, we need to go through the different types of external factors and how they are classifiedMacroeconomic FactorsCountry Regulation RulesBank Regulation RulesThese factors were not included for the following reasonsSince we are examining the performance of 92 banks (27 Islamic Banks and 65 Conventional Banks) in 6 countries, the number of countries used in the study is not significant enough to study the impact of GDP and inflation accurately on Bank profitability especially when examining each year separatelyCountry Regulation Rules as per the IMF Database, although it differs slightly for the selected countries, did not change over the per iod from 2006 to 2009. This means that for each bank, these factors remained constant.Data about Bank Regulation Rules could not be obtained for GCC banksDelimitation of the StudyThis study was delaminated to the Islamic and Conventional Banks in the GCC whose data could be obtained in the Bankscope database.Chapter 2 Literature ReviewOverview of Islamic BankingIslamic Baking has established as an alternative to conventional interest-based banking. The first stirring of the Islamic Banking movement began in 1963 by Dr. Ahmed Alnajar in a small town in Egypt, called Mit Ghamar. Dr. Alnajar completed his education in Germany and found that it had many saving banks operating on interest. He took the idea from a savings bank in Germany and created his own small Islamic bank that was interest free.After Dr. Alnajars small bank proved successful, the establishment of other Islamic banks followed. In 1971, the Nasser Social Bank was founded in Egypt with the objective of lending out money as a charity on the basis of a profit and loss sharing system and helping people in need. And in 1975, the idea of Islamic banking spread to other Islamic regions such Dubai Islamic bank in United Arab Emirates and The Islamic Development (IDB) Bank in Jeddah, Saudi Arabia (Wilson, 1990).Even though Islamic Banking has only been around for thirty years and is still in an evolving stage, Islamic Banking is the fastest growing segment of the credit markets in the Muslim countries. In 2009, Assets held by Islamic Banking banks rose by 28.6 percent to $822bn from $639bn in 2008, according to The Bankers Top 500 Islamic Financial Institutions? survey while conventional banks posted annual asset growth of just 6.8 percent.Furthermore, GCC states accounted for $353.2bn or 42.9 percent of the global aggregate, while Iran remained the largest single market for Shariah-compliant assets, accounting for 35.6 percent of the total.Source Asian Banker Research, 2009Finally, Islamic banking operati ons are not limited to Islamic countries but are spreading throughout the world. One reason is the growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity that could have a significant impact on the pattern of world trade (Abdel-Magid, 1981).Islamic Banking Rules and PrinciplesIslamic banking rules are according to the Islamic Shariah derived from the Quran and prophet Mohameds sayings. The three main practices that are clearly prohibited in the Quran and the prophets sayings are, Riba (Interest), Gharar (Uncertainty), and Maysir (Betting).Prohibition of Riba or any predetermined or fixed rate in financial institutions is the most important factor in the Islamic principles pertaining to banking. As stated in the Quran Allah forbids riba?. Riba means an increase and under Shariah the term refers to the premium that must be paid by the borrower to the lender along with the principle amount as a condition for the loan (Omar and A bdel, 1996).Gharar occurs when the purchaser does not know what has been bought and the seller does not know what has been sold. In other words, trading should be clear by stating in a contract the existing actual object(s) to be sold, with a price and time to eliminate confusion and uncertainty between the buyers and the sellers.Maisir is considered in Islam as one form of injustice in the appropriation of others wealth. The act of gambling, sometimes referred to betting on the occurrence of a future event, is prohibited and no reward accrues for the employment of spending of wealth that an individual may gain through means of gambling. Under this prohibition, any contract entered into, should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions.Therefore, and according to Ahmed and Hassan (2007), the principles of Islamic banking and finance enshrined from al-Quran and Prophet Mohameds Sayings can be summed up as followsAny predetermined payment over and above the actual amount of principal is prohibited.The lender must share in the profits or losses arising out of the enterprise for which the money was lent.Making money from money is not acceptable in Islam.Gharar (deception) and Maisir (gambling) are also prohibited.Investments should only support practices or products that are not forbidden or even discouraged by Islam.Islamic Banking ProductsIslamic Banking products have to be done according to Islamic rules and principles, based on profit and loss sharing as well as avoiding interest. According to BNM statistics 2007, Al Bai Bithaman Ajil financing is the most common in Islamic Banking. There are a lot of Islamic Banking products however there are some famous Islamic products that will be discussed in this section.Al Bai Bithaman Ajil /BBAThis involves the credit sale of goods on a deferred payment basis. In BAA, the Islamic bank will purchase certain assets on a deferred payment basis and then sell the goods back to the customer at an agreed price including some margin or profit. The customer will make payment by installments over an agreed period. A fixed rate BBA is a powerful hedging tool against interest rates (Rosly, 1999).MurabahahMurabahah is a contract of sale. The Islamic Bank acts as a middle man and purchases the goods requested by the customer. The bank will later sell the goods to the customer in a sale and purchase agreement, whereby the lender re-sales to the borrower at a higher price agreed on by both parties. These are more for short term financingMudharabahAccording to Kettel (2006), Mudharabah is a basic principle of profit and loss, where instead of lending money at a fixed rate return, the banker forms a partnership with the borrower, thereby sharing in a ventures profit and loss. Mudharabah is an agreement between the lender and entrepreneur, whereby the lender agrees to finance the project on a profit sharing basis according to a predetermined ratio agreed by both parties concerned. If there are any losses the lender will bear all the losses.MusharakahMusharakah means partnership whereby the Islamic institution provides the capital needed by the customer with the understanding that they both share the profit and loss according to a formula agreed before the business transaction is transacted. In Musharakah all partners are entitled to participate in the management of the investment but it is not compulsory. Musharakah can help in providing financing for large investments in modern economic activitiesAl IjarahIjarah means meaning to give something on a rental basis. In Ijarah, the bank acquires ownership based on the promise and leases back to the client for a given period. The customer pays the rental but the ownership still remains with the bank or lender. As the ownership remains with the lessor (bank), it continues to give the service for which it was rente d. Under this contract, the lessor has the right to re-negotiate the quantum of the lease payment at every agreed interval to ensure rental remains in line with the market rates (Hume, 2004).WadiahWadiah is a trust contract and the bank provides gift (hibah) and various types of benefits to the customer. This is exactly like a normal conventional savings account.IstisnaIstisna allows one party buys the goods and the other party undertakes to manufacture them according to agreed specifications. Normally, Istisna is used to finance construction and manufacturing projects.SalamSalam is defined as the forward purchase of specified goods with full forward payment. This contract is normally used for financing agricultural production. According to Hassan (2004), Salam based future contracts for agricultural commodities, supported by Islamic Banks, can help to overcome the agricultural financial problemsTable 2.1 lists the products of conventional banking and their correspondent products in Islamic Banking.Deposit ServicesCurrent DepositWadiah Wad Dhamana / Qard HasanSavings DepositWadiah Wad Dhamana / MudarabaGeneral Investment depositMudarabaSpecial Investment depositMudarabaRetail / Consumer BankingHousing Property FinanceBBA / Ijara wa Iktina /Diminishing MusharakaHire PurchaseIjara Thumma Al-BaiShare FinancingBBA / Mudaraba / MusharakaWorking Capital FinancingMurabahah/ Bai Al-Einah/ TawarruqCredit CardBai Al-Einah/ TawarruqCharge CardQard HasanCorporate Banking/ Trade FinanceProject FinancingMudaraba / Musharaka / BBA / Istisna / IjaraLetter of CreditMusharaka/ Wakala/ MurabahaVenture CapitalDiminishing Mudaraba/ MusharakaFinancing SyndicationMusharaka + Murabaha/ Istisna / IjaraRevolving FinancingBai Al-EinahShort-term Cash AdvanceBai Al-Einah/ TawarruqWorking Capital FinanceMurabaha/ Salam/ IstijrarLetter of CreditMurabahaLetter of GuaranteeKafala + UjrLeasingIjaraExport/ Import FinanceMusharaka/ Salam/ MurabahaWork-in-Progress, Construction FinanceIstisnaBil l DiscountingBai al-DaynUnderwriting, Advisory ServicesUjrTreasury / Money Market Investment ProductsSell buy-back agreementsBai al-EinahIslamic BondsMudaraba / Mushraka + BBA / Istisna / IjaraGovernment Investment IssuesQard Hasan/ Salam/ MudarabaOther Products ServicesStock-Broking ServicesMurabaha/ Wakala/ JoalaFunds Transfer (Domestic Foreign)Wakala/ JoalaSafe-Keeping Collection (Negotiable Instruments)Wakala/ JoalaFactoringWakala/ Joala/ Bai al-DaynAdministration of Property, Estates and WillsWakalaHiring of Strong BoxesAmana/ WakalaDemand Draft, Travellers ChequesUjr/ JoalaATM Service, Standing Instruction, TelebankingUjrSource Obaidullah, 2005Financial Crisis and the Islamic BankingPrevious LiteratureThe study of bank profitability is an important tool to evaluate bank operation by examining the different factors affecting bank profitability and using these factors for management planning and strategic analysis. In the last four decades, many studies have been conducted t o study both bank profitability and the determinants of bank profitability either for particular country or for a panel of countries. These studies normally divide these factors into internal factors and external factors. Internal factors represent the bank-specific characteristics such as bank size, liquidity structure liabilitiesetc while external factors can be macroeconomic factors such as inflation and GDP growth or Country-specific regulations rules and practices.In the area of banking profitability, many studies have been conducted to investigate the profitability of conventional banks while only few were conducted in the field of Islamic banking. In this chapter, we will review these studies for conventional banking first and then will focus on studies in the Islamic banking field. Then we will cover the conceptual framework of this research.Conventional BankingDifferent studies have been conducted in the field of conventional banking profitability. Short (1979), Bourke (198 9), Molyneux and Thornton (1992), Goddard, Molyneux, and Wilson (2004), Peters et al. (2004) are some of the researchers in the field.Short (1979) is one of the early scholars who studied the relationship between banking profit rates and concentration for sixty banks in Canada, Western Europe and Japan during the 1970s and he included independent variables including government ownership and concentration by using H index to quantify concentration. Results showed that the government ownership impact on profitability varied throughout the countries studied but expressed an overall negative relationship. He also found evidence that indicated higher concentration rates lead to higher profit rates (Short, 1979).Bourke (1989) also compared concentration to bank profitability but included other determinants. Bourke (1989) covered ninety banks in Australia, Europe, and North America between 1972 and 198 and examined different internal and external factors internal factors such as staff expe nses, capital ratio, liquidity ratio, and loans to deposit ratio external factors such as regulation, size of economies of scale, competition, concentration, growth in market, interest rate, government ownership, and market power. His results show that increase in government ownership leads to lower profitability in banking. He also found that concentration, interest rates, and money supply are positively related to profitability along with capital and reserves of total assets as well as cash and bank deposits of total assets. Bourke adds that well capitalized banks enjoy cheaper access to sources of funds as they are less risky than less capitalized banks (Bourke, 1989).Later, Molyneux and Thornton (1992) studied the determinants of European banks profitability. The paper examined eighteen counties in Europe between 1986 and 1989. This paper replicated Bourkes (1989) work by using internal and external determinants of bank profitability. However, Molyneux and Thornton (1992) result s showed that government ownership expresses a positive coefficient with return on capital (profitability) which contradicts with Bourkes findings. Other results were similar to Bourkes, showing that concentration, interest rate, and money supply were positively related to bank profitability (Molyneux and Thornton, 1992).In one of the recent papers on bank profitability on European banks, Goddard, Molyneux, and Wilson (2004) shows similar findings to the paper by Molyneux and Thornton (1992). It investigates the determinants of profitability in six European countries and it covered 665 banks between 1992 and 1998. The study used cross-sectional and dynamic panel models. The variables used in the regression analysis were ROE, the logarithmic of total assets, Off Balance Sheet (OBS) dividends, Capital to Asset Ratio (CAR). The results from both models were similar evidence reveals that there is a positive relationship between size (total assets) and profitability. Meanwhile, OBS appea rs to have a positive relationship with profitability for UK but neutral or negative for other European countries. Moreover, results also state that CAR has a positive relationship with profitability. Furthermore, the paper touched on ownership type by indicating that there is high competition in banking due to the fact that there is foreign bank involvement in domestic banks, and that profitability is not linked to ownership (Goddard, Molyneux, and Wilson, 2004).Peters et al. (2004) studied the characteristics of banks in post-war Lebanon for the years 1993 to 2000 and compared the results to a group of banks from five other countries in the Middle East including UAE, KSA, Kuwait, Bahrain and Oman for the years 1995 through 1999. They used Return on Equity (ROE) measure profitability and leverage and they employed regression models that relate bank profitability ratios to various explanatory variables. This study tests the relationships between bank profitability and size, asset po rtfolio composition, off-balance sheet items, ownership by a foreign bank, and the ratio of employment to assets. The results show a strong association between economic growth and bank profitability, whether measured by ROE or ROA. They found that Lebanese banks are profitable, but not as profitable as a control group of banks from five other countries located in the Middle East.Islamic BankingIn the area of Islamic Banking, Bashir (2000) assessed the performance of Islamic banks in eight Middle Eastern countries. He analyzed important bank characteristics that affect the performance of Islamic banks by controlling economic and financial structure measures. The paper studied fourteen Islamic banks from Bahrain, Egypt, Jordan, Kuwait, Qatar, Sudan, Turkey, and United Arab Emirates between 1993 and 1998. To examining profitability, the paper used Non Interest Margin (NIM), Before Tax Profit (BTP), Return on Assets (ROA), and Return on Equity (ROE) as performance indicators. There were also internal and external variables internal variables were bank size, leverage, loans, short-term funding, overhead, and ownership external variables included macroeconomic environment, regulation, and financial market. In general, results from the study confirm previous findings and show that Islamic banks profitability is positively related to equity and loans. Consequently, if loans and equity are high, Islamic banks should be more profitable. If leverage is high and loan to assets is also large, Islamic banks will be more profitable. The results also indicate that favorable macro-economic conditions help profitability (Bashir, 2000).Hassoune (2002) examined Islamic bank profitability in an interest rate cycle. In his paper, compared ROE and ROA Volatility for both Islamic and conventional banks in three GCC region, Kuwait, Saudi Arabia, and Qatar. He states that since Islamic banking is based on profit and loss sharing, managements have to generate sufficient returns for inve stors given that they are not willing accept no returns (Hassoune, 2002).Bashir and Hassan (2004) studied the determinants of Islamic banking profitability covers 43 Islamic Banks between 1994 and 2001 in 21 countries. Their figures show Islamic banks to have a better capital asset ratio compared to commercial banks which means that Islamic banks are well capitalized. Also, their paper used internal and external banks characteristics to determine profitability as well as economic measures, financial structure variables, and country variables. They used, Net-non Interest Margin (NIM), which is non interest income to the bank such as, bank fees, service charges and foreign exchange to identify profitability. Other profitability indicators adopted were Before Tax Profit divided by total assets (BTP/TA), Return on Assets (ROA), and Return on Equity (ROE).Results obtained by Bashir and Hassan (2004), were similar to the Bashir (2000) results, which found a positive relationship between c apital and profitability but a negative relationship between loans and profitability. Bashir and Hassan also found total assets to have a negative relationship with profitability which amazingly means that smaller banks are more profitable. In addition, during an economic boom, banks profitability seems to improve because there are fewer nonperforming loans. Inflation, on the other hand, does not have any effect on Islamic bank profitability. Finally, results also indicate that overhead expenses for Islamic banks have a positive relation with profitability which means if expenses increase, profitability also increases (Bashir and Hassan, 2004).Alkassim (2005) examined the determinants of profitability in the banking sector of the GCC countries and found that asset have a negative impact on profitability of conventional banks but have a positive impact on profitability of Islamic banks. They also observed that positive impact on profitability for conventional but have a negative impa ct for Islamic banking. Liu and Hung (2006) examined the relationship between service quality and long-term profitability of Taiwans banks and found a positive link between branch number and long-term profitability and also proved that average salaries are detrimental to banks profit.Masood, Aktan and Chaudhary (2009) studied the co-integration and causal relationship between Return on Equity and Return on Assets for 12 banks in KSA for the period between 1999- 2007. For their research, the used time series model of ADF unit-root test, Johansen co-integration test, Granger causality test and graphical comparison model. They found that there are stable long run relationships between the two variables and that it is only a one-direction cause-effect relationship between ROE and ROA. The results show that ROE is a granger cause to ROA but ROA is not a granger cause to ROE that is ROE can affect ROA input but ROA does not affect the ROE in the Saudi Arabian Banking sector.Conceptual Fra meworkTheoretical framework is a basic conceptual structure organized around a theory. It defines the kinds of variables that are going to be used in the analysis. In this research, the theoretical framework consists of seven independent variables that represent four aspects of the Bank Characteristics. Theses aspects are the Bank Size (Total Assets), Capital Structure (Equity and Tangible Equity), Liquidity (Loans and Liquid Assets) and Liabilities (Deposits and Overheads). Bank profitability is the dependent variable and two measures of bank profitability are used in this study, namely return on average equity (ROAE) and return on average assets (ROAA).Financial CrisisInternal Factors (Bank-Specific)Islamic Banking ProfitabilityH1 Bank SizeH2, H3 Capital StructureH4, H5 LiquiditiesH6, H7 LiabilitiesReturn on Average Assets (ROAA)Return on Average Equity (ROAE)In this section we develop the hypothesis to be examined in this research paper.Development of HypothesesThis paper attempt s to test seven hypotheses. A hypothesis is a claim or assumption about the value of a population parameter. It consists either of a suggested explanation for a phenomenon or of a reasoned proposal suggesting a possible correlation between multiple phenomena. According to Becker (1995), hypothesis testing is the process of judging which of two contradictory statements is correct.Hypothesis 1 Profitability has a positive and significant relationship with the total assets (ASSETS).Total Assets of a company represents its valuables including both tangible assets such as equipments and properties along with its intangible assets such as goodwill and patent. For banks, total assets include loans which are the basis for bank operations either through interest or interest-free practices. Total assets is used as a tool to measure the bank size banks with higher total assets indicate bigger banks. Molyneux and el (2004) included total assets in their study and found a positive significant re lationship between total assets and profitability. Therefore, total assets are expected to have positive relation with profitability which means that bigger banks are expected to be more profitable. Total assets are converted logarithmic to be more consistent with the other ratiosHypothesis 2 Profitability has a positive and significant relationship with equity to asset ratio (EQUITY).Total equity over total assets measures banks capital structure and adequate. It indicated bank ability to withstand losses and handle risk exposure with shareholders. Hassan and Bashir (2004) examined the relationship between EQUITY and bank profitability and found positive relationship. Therefore, EQUITY is included in this study and it is expected to have a positive relation with performance because well capitalized banks are less risky and more profitable (Bourke, 1989)Hypothesis 3 Profitability has a positive and significant relationship with Tangible Equity to total liabilities ratio (TNGEQTY).Ta ngible Equity represents the subset of shareholders equity that is not common shares and not intangible asset. Tangible Equity became very popular after the financial crisis as a measure of bank viability since it indicates of how much ownership equity owners of common stock would receive in the event of a companys liquidation. Beltratti and Stulz (2009) examined tangible equity to liabilities in their study to examine why some banks perform better during the financial crisis and found positive and insignificant relationship between TNEQTY and bank profitability. Therefore, TNEQTY is included in this study and it is expected to have positive relationship since banks with better capital structure in since of more equity seems to perform better.Hypothesis 4 Profitability has a positive and significant relationship with the loans to assets ratio (LOANS).Total loans over total assets a liquidity ratio used that indicates how much of bank assets are tied to loans. For banks, the higher LOANS ratio means less liquidity. Demirguc-Kunt and Huizinga, (1997) found positive relationship between LOANS and bank profitability. LOANS is included in this study and anticipated to have positive relationship with profitability. Furthermore, conventional banks rely on interest-based loans while Islamic banks rely on profit and loss sharing interest-free lending. Therefore, this ratio is also used to compare the performance of interest-based loans and interest-free lending.Hypothesis 5 Profitability has a positive and significant relationship with the liquid assets to total assets ratio (LIQUID).Liquid assets include currency, deposit accounts, and negotiable instruments that can be converted easily into cash. Liquid assets to total assets ratio is a liquidity ratio that measure how easily the banks assets can be converted into cash. Beltratti and Stulz (2009) found that LIQUID has positive and significant relation with profitability as banks with more liquid assets tend to perf orm better. Therefore, LIQUID is included in this study and expected to have positive relationship with profitability.Hypothesis 6 Profitability has a reverse and significant relationship with the deposits to assets ratio (DEPOSITS).Deposits to total ratio is another liquidity indicator but is considered a liability since they measure the impact of liabilities on profitability. Bashir and Hassan (2004) examined deposits in their study and found a negative relationship with profitability. Therefore, we expect that DEPOSITS to have negative relationship with profitability.Hypothesis 7 Profitability has a positive and significant relationship with the overhead to assets ratio (OVERHEAD).Overhead costs represent all bank expenses excluding interest expenses as they are considered as operations expenses. Overhead over total assets is a liability ratio that measures the operation efficiency of the bank. Alkassim (2005) included OVERHEAD in his research and found positive relationship to p rofitability. Therefore, OVERHEAD is included in this study and expected to have positive relationship to profitability.Chapter 3 MethodsData SampleFrom 2006 to 20082009CountryIslamic BanksConventional BanksIslamic BanksConventional BanksBahrain121455Saudi Arabia2917Qatar3524Kuwait41413Oman0603UAE61707Total2765929The data used in this analysis were extracted from Bankscope data for all Islamic and Conventional Banks in the GCC for the period from 2006 to 2009.Using Bankscope has many advantages it has information for over 30,000 banks, plus the accounting information is presented in a standardized format. Therefore, the accounting information of Islamic Banking is adjusted to be comparable with accounting information of conventional banks.The data used for this study are from a pooled time-series cross-sectional data. The data are taken from various countries. Sample period for this study is from 2002 to 2007. Cross-sectional data provide information on variables for a given period of time. While time series data give information about variables over a number of periods of time.The data for internal variables are obtained from BankScope database which is compiled by International Bank Credit Analysis Limited (IBCA). Using BankScope has two advantages. Firstly, it has information for 11,000 banks, accounting for about 90% of total assets in each country. Secondly, the accounting information at the bank level is presented in standardized formats, after adjustments for differences in accounting and reporting standards. The data for external variables are obtained from World Economic Outlook 2008 database, published by International Monetary Fund (IMF).A total of 60 Islamic banks from 18 countries were chosen in this study. The selected banks are those which are classified as Islamic bank in BankScope database. The Islamic banks have available data for at least one year between 2002 and 2007. This yielded an unbalanced panel data consisting of 260 observations. Ho wever, after eliminating cases with missing data, only 155 observations of balanced panel data are left.Variable DefinitionIndependent Variable Profitability MeasuresThere are many ratios that have been used by researchers to measure bank profitability but the two most often used ratios are the return on assets (ROA) and the return on equity (ROE) (Iqbal et al., 2005).Return on Assets