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. Introduction
The 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
Review of Islamic Economics, Vol. 13, No. 1, 2009 7

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
8 Review of Islamic Economics, Vol. 13, No. 1, 2009

(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 Review

The 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
Review of Islamic Economics, Vol. 13, No. 1, 2009 9

(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.
10 Review of Islamic Economics, Vol. 13, No. 1, 2009

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 GCC

The 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).
Review of Islamic Economics, Vol. 13, No. 1, 2009 11

Table 1: Aggregate Economic Indicators of the GCC countries (2006)

Money Current
Nominal Nominal Real
Average Supply Account
Population GDP GDP Per GDP
Country inflation (M2) Balance
(Million) (million Capita growth
(%) (million (% of
$) ($) (%)
$) GDP)

Bahrain 0.749 15823 2.2 10734 21123 13.35 6.54

Kuwait 3.483 98717 3.1 55062 31014 43.71 6.28
Oman 2.546 35729 3.2 11569 14032 12.11 6.78
Qatar 0.838 52722 11.8 24357 62914 30.56 10.34
Saudi A. 23.697 345138 2.3 143672 14733 27.35 4.29
UAE 4.229 163293 9.3 107419 38613 22.01 9.38

Total or
35.242 711425 5.4 352813 30405 27.2 7.27
Average

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
12 Review of Islamic Economics, Vol. 13, No. 1, 2009

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 sector

The 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.
Review of Islamic Economics, Vol. 13, No. 1, 2009 13

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)

Assets Loans
Deposits
Assets to Loans to Deposits ROE ROA
Country Banks to GDP
(B$) GDP (B$) GDP (B$) (%) (%)
(%)
(%) (%)
Bahrain 25 23092 146 12744 80.5 12002 75.8 19.2 1.6
Kuwait 9 93346 94.5 63346 64.2 57760 58.5 21.3 2.9
Oman 5 18724 32.7 11697 32.7 12014 33.6 18.2 2.5
Qatar 8 52055 98.7 31162 59.1 32775 62.2 21 2.9
Saudi A. 11 229623 66.4 169353 49.1 157669 45.7 30.1 3.9
UAE 21 234216 144 129111 79.1 128287 78.6 18.6 2.4
Total or
79 651056 97.05 417413 60.78 400507 59.06 21.4 2.7
average
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.
14 Review of Islamic Economics, Vol. 13, No. 1, 2009

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. Data
The 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

Conventional Islamic Total number

Country
Banks Banks of banks
Bahrain 7 6 13
Kuwait 6 4 10
Oman 5 - 5
Qatar 6 2 8
Saudi Arabia 9 1 10
UAE 15 5 20
Total 48 18 66
Review of Islamic Economics, Vol. 13, No. 1, 2009 15

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 variables

Table 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 determinants

The 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
16 Review of Islamic Economics, Vol. 13, No. 1, 2009

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.
Review of Islamic Economics, Vol. 13, No. 1, 2009 17

Table 4: Description of Variables

Expected
Variables Notation Description
Effect
Dependent
Profitability ROAA The return on average total assets of the bank
Independent
Bank-Specific (internal factors)
Equity/total Assets. High ratios are assumed to
Capital
EQA be indicators of low financial capital leverage
Adequacy +
and hence low risk.
Loans/Deposits and short-term funding. The
Liquidity
LQR higher this ratio the less liquid the bank will
Ratio +
be.
Net Loans/Total Assets. The higher this ratio
Credit Risk NLA
the less risk assumed by bank. +
Financial Risk Total Liabilities/Total Assets. The higher this
LTA
ratio, the higher bank profitability. +
Cost/Income. This ratio provides information
Operational on the efficiency of the management regarding
COI
Efficiency expenses to the revenues it generates. Higher -
ratio indicates a less efficient management.
Size TA Log Total Assets +/-
Macroeconomic (external factors)
(CPIt-CPIt-1)/CPIt-1. To proxy this variable we
Inflation Rate INF use the growth of the Consumer Price Index
+/-
:CPI
Real Gross
Domestic (RGDPt-RGDPt-1)/RGDPt-1. GDP is a general
RGDP
Product index of economic development +
Growth
Growth Rate (M2t-M2t-1)/M2t-1. M2=Current in circulation
of Money M2 + Private demand deposits in local currency
+
Supply with banks + quasi-monetary deposits.
Financial Industry
Credit to private sector/GDP. This variable is
Banking
more than a simple measure of banking sector
Sector CPGDP
size, it also used to measure the importance of +
Development
bank financing in the economy.
Stock Market Capitalization/GDP. This ratio
Financial
measures the overall level of development of
Market SMGDP
the market and its importance in financing +
Development
economy.
Assets of the three largest banks/total Assets.
The higher the concentration ratio, the more
Concentration CONC
monopoly power there is in the banking ?
system
18 Review of Islamic Economics, Vol. 13, No. 1, 2009

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 determinants

To 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 determinants

In addition to macroeconomic variables, the performance of banks is related
to the relative development of the banking industry and the stock market. We
Review of Islamic Economics, Vol. 13, No. 1, 2009 19

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 formulation

To 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 Xi,t + β2Zt + εi,t (1)

20 Review of Islamic Economics, Vol. 13, No. 1, 2009

where ROAAi,t is the return on average assets for bank i in year t, α is a

constant, Xi,t represents the vector of characteristics of bank i in year t,
Zt represents the external factors, β1 and β2 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 (vi) is taken to be constant over time and the functional form of one-
way panel data model is as follows:

ROAAi,t = (α + vi ) + β1 Xi,t + β2Zt + ui,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 Xi,t + β2Zt + ui,t + vi (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 statistics
Before 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.
Review of Islamic Economics, Vol. 13, No. 1, 2009 21

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.
22 Review of Islamic Economics, Vol. 13, No. 1, 2009

5.2. Regressions results

To 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.
Review of Islamic Economics, Vol. 13, No. 1, 2009 23

Table 6: Regression Results (Fixed Effect Model)

Conventional
Variables All banks Islamic banks
banks
EQA
0.064 0.049 0.054
(6.449)* (5.076)* (2.701)*
LQR
0.001 -0.005 0.049
(0.368) (-1.002) (1.953)**
NLA
0.017 -0.015 0.044
(1.704)*** (-1.958)** (1.862)***
LTA
0.352 0.023 0.414
(5.316)* (1.282) (4.678)*
COI
-0.064 -0.046 -0.076
(-8.456)* (-8.535)* (-5.144)*
TA
0.216 -0.066 -0.439
(2.104)** (-1.315) (-1.491)
INF
0.023 -0.046 0.031
(1.525) (-0.160) (1.035)
RGDP
0.083 0.018 0.012
(2.218)** (2.361)** (1.982)**
M2
0.020 0.038 0.029
(3.182)* (2.358)** (2.200)**
CPGDP
0.050 0.011 0.009
(0.424) (1.248) (0.684)
0. 783 0.481 0.021
SMGDP
(2.166)** (2.233)** (1.737)***
0.217 0.161 -
CONC
(2.563)** (2.927)*
0.509 0.653 0.413
Adjusted R2
46.679 61.097 9.412
F value
456.22 320.36 185.54
LM
35.14 29.67 23.15
Hausman test
528 384 144
Nb. observations
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,
24 Review of Islamic Economics, Vol. 13, No. 1, 2009

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
Review of Islamic Economics, Vol. 13, No. 1, 2009 25

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. Conclusion
In 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.
26 Review of Islamic Economics, Vol. 13, No. 1, 2009

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
Review of Islamic Economics, Vol. 13, No. 1, 2009 27

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.
28 Review of Islamic Economics, Vol. 13, No. 1, 2009

Notes
1. GCC Banking May, 2007: Institute of Banking Studies, Kuwait
2. 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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