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Does foreign presence foster Islamic banks' performance? Empirical evidence from
Malaysia
Fadzlan Sufian
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Article information:
To cite this document:
Fadzlan Sufian, (2010),"Does foreign presence foster Islamic banks' performance? Empirical evidence from
Malaysia", Journal of Islamic Accounting and Business Research, Vol. 1 Iss 2 pp. 128 - 147
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http://dx.doi.org/10.1108/17590811011086723
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Fadzlan Sufian
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1. Introduction
Islamic banks today exist in all parts of the world and are looked upon as a viable
alternative system. While it was initially developed to fulfill the needs of Muslims,
Islamic banking has now gained universal acceptance. In Malaysia, the first Islamic
bank was established in 1983. It was only after ten years that the government allowed
other conventional banks to offer Islamic banking services under their existing
infrastructure and branches. The move to create Islamic banking window operations
allowed the country to enjoy Islamic banking services at the lowest cost and within the
shortest time frame. Recently, Malaysia has succeeded in implementing a dual banking
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system and has emerged as among the first nations to have a full-fledged Islamic
banking system operating side by side with the conventional banking system[1].
The Malaysian Islamic banking sector has gained its significance and since the year
2000, the industry has been growing at an average rate of 18.9 percent per annum in
terms of assets. Figure 1 shows the growth of total assets (TA) of the Malaysian Islamic
banking sector from a mere RM1.2 billion in 1996 to RM157.1 billion in 2007, accounting
for 12.8 percent of the banking systems TA. The market share of Islamic bank deposits
and financing stood at 14 percent of the total banking sectors deposits and financing.
With the growth in Islamic banking industry far surpassing the expansion in the
banking systems asset base, the industry is expected to be able to achieve the
governments aspiration for the Islamic banking assets to make up 20 percent of the
banking systems TA by the year 2020.
It has been the Malaysian Governments aspiration to develop the country as the
capital or hub of Islamic banking worldwide. To meet the objective, the government has
taken measures, which among others include liberalizing the Malaysian Islamic
banking sector. The strategy is to create more competition, to tap new growth
opportunities, and to raise the efficiency of the Malaysian Islamic banking industry as a
whole. The Malaysian Governments commitment is evidenced by the issuance of
licenses to three foreign banks from the Middle East, namely, Kuwait Finance House,
Al-Rajhi Banking and Investment Corporation, and Al-Baraka Islamic Bank, to operate
as full-fledged Islamic banks in the country (Sufian and Haron, 2008). The entry of new
foreign players is deemed to have a positive effect in terms of Islamic product
innovation and development, but the smaller players will now have to strive to drive
business volumes and establish their positions within the Islamic banking industry as
competition intensifies (Sufian and Haron, 2008).
These developments posed great challenges to the local Islamic banks as the
environment in which they operate has changed rapidly and consequently, impact on
their performance. Despite the Islamic banking sectors considerable development in
14
12.2
12
Foreign presence
129
12.8
11.3
10.5
10
8
6.9
%
5.5
5.9
4.4
3.4
4
2.5
2
1.9
1.2
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Bank Negara Malaysia (1996-2007)
Figure 1.
Islamic banking assets as
percentage of Malaysian
Banking System Assets
1996-2007
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130
the country, empirical works on Islamic banks performance are still in its infancy.
The paper therefore attempts to fill the gap in the literature by providing new empirical
evidence on the impact of foreign bank entry on the performance of the Malaysian
Islamic banking sector. This paper will also explore whether the De Novo foreign
Islamic banks are relatively more profitable than their incumbent bank counterparts.
Evidences from contemporary banking industry suggest that foreign banks in
developing countries outperformed their domestic bank counterparts in terms of
efficiency, productivity, and profitability (Bhattacharya et al., 1997; Sathye, 2001;
Hasan and Marton, 2003; Isik and Hassan, 2003; Ataullah et al., 2004). This paper will
therefore shed some light on the impact of ownership structure in determining the
variability of bank performance within the context of Malaysian Islamic banking
sector.
Various commonly used accounting-based measures of financial institutions
performance have been gathered from the yearly financial statements of two fully
fledged domestic Islamic banks, three fully fledged foreign Islamic banks, 11 domestic
banks with Islamic windows, and four foreign banks with Islamic windows for the
period 2001-2007. We first examine the performance of the Malaysian Islamic banking
sector by employing a series of parametric and non-parametric univariate tests before
proceeding to examine the determinants of the Malaysian Islamic banking sectors
performance based on multivariate analysis.
The paper is divided into six sections. The following section presents the literature
review. Section 3 describes the data, sources, and models employed in the paper.
Empirical results are presented in Section 4. The discussions on the results and policy
implications are presented in Section 5, and finally, Section 6 presents the conclusion.
2. Review of the literature
The literature examining the performance of financial institutions has expanded
rapidly in recent years. However, empirical works on the performance of the Islamic
banking sector are still in its infancy. El-Gamal and Inanoglu (2005) pointed out that
studies on Islamic bank performance have mainly focused on theoretical issues and the
empirical works have relied mainly on the analysis of descriptive statistics rather than
rigorous statistical estimations.
Although a large body of literature has examined the performance of the
conventional banking sector (see surveys in Berger et al., 1993; Berger and Humphrey,
1997; Berger, 2007; and references therein), more recent studies have examined the
performance of the Islamic banking sector in countries such as Sudan (Hussein, 2003;
Hassan and Hussein, 2003), Turkey (El-Gamal and Inanoglu, 2004), and Malaysia
(Sufian and Haron, 2008; Mokhtar et al., 2008; Sufian, 2007). Apart from focusing on a
specific country, there are also several other studies which have examined the
performance of the Islamic banking sector on a cross-country setting (Hassan et al.,
2009; Sufian and Mohamad Noor, 2009; Bader et al., 2008; Ascarya and Yumanita, 2008;
Viverita et al., 2007; Hassan, 2006).
While the above outlines the literature that uses advanced modelling techniques to
evaluate the performance of the Islamic banking sector, there is also a growing body of
literature that covers the determinants of Islamic banks performance. Such studies
include those by Hassan and Bashir (2003) who looked at the determinants of Islamic bank
performance. They concluded that Islamic banks are just as efficient as conventional
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The LNTA variable is included in the regression as a proxy of size to capture the
possible cost advantages associated with size (economies of scale). In the literature,
mixed relationships are found between size and profitability, while in some cases a
U-shaped relationship is observed. LNTA is also used to control for cost differences
related to bank size and ability of larger banks to diversify. In essence, LNTA may lead
to positive effects on banks profitability if there are significant economies of scale.
On the other hand, if increased diversification leads to higher risks, the variable may
exhibit negative effects.
EQASS variable is included in the regression models to examine the relationship
between profitability and bank capitalization. Strong capital structure is essential for
banks in developing economies since it provides additional strength to withstand
financial crises and increases safety for depositors during unstable macroeconomic
conditions. Furthermore, lower capital ratios in banking imply higher leverage and risk,
and therefore greater borrowing costs. Thus, the profitability level should be higher for
banks that are better capitalized.
The ratio of LLP/TL is incorporated as an independent variable in the regression
analysis as a proxy for credit risk. The coefficient of LLP/TL is expected to be negative
because bad loans are expected to reduce profitability. Miller and Noulas (1997) suggest
that the greater the exposure of the banks to high risk loans, the higher would be the
accumulation of unpaid loans and the lower the level of profitability. Miller and Noulas
(1997) further suggest that decline in LLP are in many instances the primary catalyst for
increases in profit margins. Thakor (1987) suggests that the level of LLP is an indication
of the banks asset quality and signals changes in future performance.
The ratio of NIE/TA is used to provide information on the variations of bank
operating costs. The variable represents total amount of wages and salaries as well as
the costs of running branch office facilities. The relationship between the NIE/TA
variable and profitability levels may be negative because banks that are more productive
and efficient should keep their operating costs low. Furthermore, the usage of new
electronic technology like ATMs and other automated means of delivering services may
reduce expenses on wages (as capital is substituted for labour).
An important decision that managers of Islamic banks need to consider in relation to
liquidity management is in terms of determining their needs and managing the process
of deposits and loans. Hence, the ratio of LOANS/TA is used as a measure of liquidity
with higher figures denoting lower liquidity. Without the required liquidity and
funding to meet obligations, a bank may fail. Thus, in order to avoid insolvency
problems, bank often hold liquid assets which can be easily converted to cash. However,
liquid assets are usually associated with lower rates of return. It would therefore be
reasonable to expect higher liquidity to be associated with lower bank profitability.
The variable LNDEPO is included in the regression model as a proxy variable for
branch networks. Islamic banks with more branch networks are able to attract more
deposits and will have access to cheaper source of funds. Chu and Lim (1998) in their
study suggest that large banks may attract more deposits and loan transactions and in
the process command larger interest rate spreads. On the other hand, smaller banking
groups with smaller base of depositors may have to resort to purchasing funds in the
inter-bank market which is often costlier (Randhawa and Lim, 2005). However, given
that small banks have smaller base of depositors, they will thus have lesser deposits to
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transform into loans and would be in a better position to attain higher efficiency levels
compared to their larger counterparts (Randhawa and Lim, 2005).
3.3 External determinants
If analysis is done in a static setting, they may fail to capture developments in the
regulatory environment and in the marketplace, which may have changed due to the
underlying production technology and the associated production functions.
Furthermore, different forms of banking would react to environmental changes
differently. Hence, the change in the financial landscape and structure may vary across
banking groups (Saunders et al., 1990; Button and Weyman-Jones, 1992; Berger et al.,
1995). To test the relationship between economic and market conditions and Islamic
bank profitability, the variables LNGDP (natural log of gross domestic product) and
INFL (the annual inflation rate) are used as proxies.
GDP is among the most commonly used macroeconomic indicator to measure total
economic activity within an economy. The GDP is expected to influence numerous
factors related to the supply and demand for loans and deposits. The macroeconomic
conditions may have either pro or counter cyclical impacts on bank profitability levels.
Another important macroeconomic condition which may affect both the costs and
revenues of banks is the inflation rate (INFL). Staikouras and Wood (2003) point out
that inflation may have direct (increase in the price of labour) and indirect (changes in
interest rates and asset prices) effects on the profitability of banks. Perry (1992)
suggests that the effects of inflation on bank performance depend on whether the
inflation is anticipated on unanticipated. In the anticipated case, the interest rates are
adjusted accordingly resulting in revenues increasing faster than costs which
subsequently results in a positive impact on bank profitability. On the other hand, in
the unanticipated case, banks may be slow in adjusting their interest rates resulting in a
faster increase of bank costs than bank revenues, consequently having negative effects
on bank profitability[3].
Table I lists the variables used as proxy for profitability and its determinants.
We also include the notation and the expected effect of the determinants according to
the literature.
Table II presents the summary statistics of the dependent and the explanatory
variables for the four types of Islamic banks in panels A, B, C, and D. During the period
under study, on average, the domestic Islamic windows banks seem to be more
profitable and less liquid. On the other hand, the fully fledged domestic Islamic banks
are relatively larger, have extensive branch networks, and incur a higher amount of
provisions for loan losses. It can be observed from panel D of Table II that the fully
fledged foreign Islamic banks incur a higher level of overhead expenses and are better
capitalized compared to other types of Malaysian Islamic banks.
3.4 Model specification
To test the relationship between profitability of Islamic banks and the internal and
external determinants described earlier, we estimate a linear regression model in the
following form:
1
Y jt dt a 0jt X ijt a 0it X ejt 1jt
where j an individual Islamic bank.
t refers to year.
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Variable
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134
Dependent
ROA
Independent
Internal factors
LOANS/TA
LNTA
LLP/TL
NIE/TA
LNDEPO
EQASS
External factors
LNGDP
INFL
Bank ownership
DENOVO
Table I.
Descriptive of
the variables used
in the regression models
Period
POST
Description
Hypothesized
relationship
with profitability
NA
/2
/2
/2
/2
Ratios
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Measures
ROA
LOANS/TA
LNTA
LLP/TL
NIE/TA
Profitability
Liquidity
Size
Credit risk
Efficiency
EQASS
Capital
strength
LNDEPO
Branch
networks
0.5105
0.0336
2.9924
0.6178
9.1233
3.2242
27.2034
4.8222
6.427
5.493
7.267
0.411
0.4972
0.0545
1.7022
0.4294
10.7284
1.2167
30.0905
7.6146
5.851
4.794
6.609
0.550
1.1587
0.0938
3.4752
0.6262
8.1503
21.9019
28.8695
5.0825
6.836
5.636
7.257
0.314
5.1379
0.4527
26.0090
10.2394
36.9612
11.8537
77.1810
30.9449
6.348
4.622
8.953
1.518
Note: The table presents the summary statistics of the variables used in the regression analysis
Foreign presence
135
Table II.
Summary statistic
of dependent and
explanatory variables
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136
Table III.
Correlation matrix for
the explanatory variables
Independent
variables
LNTA EQASS LLP/TL NIE/TA LOANS/TA
LNTA
EQASS
LLP/TL
NIE/TA
LOANS/TA
LNDEPO
LNGDP
INFL
1.000
20.154
1.000
0.191 *
0.029
1.000
0.091
0.318 * *
0.054
1.000
0.257 * *
0.341 * *
0.101
0.124
1.000
LNDEPO
LNGDP
0.698 * *
0.400 * *
20.174
0.182
0.129
0.250 * *
1.000
INFL
0.250 * *
0.125
0.065
0.077
2 0.005
0.125
0.113
0.021
2 0.008
0.359 * *
0.203 *
1.000
0.675 * *
1.000
Notes: Significance at: *5 and * *1 percent levels. The table presents the results from Spearman r
correlation coefficients. The notation used in the above table is defined as follows: LNTA is a proxy
measure of size, calculated as a natural logarithm of total bank assets; EQASS is a measure of
capitalization, calculated as book value of shareholders equity as a fraction of total assets; LLP/TL is a
measure of bank risk calculated as the ratio of total loan loss provisions divided by total loans; NIE/
TA is a proxy measure for management quality, calculated as personnel expenses divided by total
assets; LOANS/TA is used as a proxy measure of loans intensity, calculated as total loans divided by
total assets; LNDEPO is a proxy measure of branch networks, measured by the natural logarithm of
total bank deposits; LNGDP is natural log of gross domestic products; INFL is the inflation rate
on the results derived from a series of parametric and non-parametric tests, before
discussing the results of the multivariate regression.
4.1 Performance of the De Novo banks relative to the incumbent banks
To examine the differences in the relative performance between the De Novo and the
incumbent banks, a series of parametric (t-test) and non-parametric (Mann-Whitney
(Wilcoxon) and Kolmogorov-Smirnov) tests were conducted and the results are
presented in Table IV.
The results from the parametric t-test suggest that the incumbent banks are relatively
more profitable (ROA) than the De Novo banks and is statistically significant at the
1-percent level (0.64692 . 2 4.87202). The De Novo banks are found to incur relatively
higher operating costs (NIE/TA), disburse lower amount of loans (LOANS/TA), and are
better capitalized (EQASS). The empirical findings also suggest that the De Novo banks
are relatively smaller (LNTA) and have lower credit risk (LLP/TL). The results from
the parametric t-test are further confirmed by the non-parametric Mann-Whitney
(Wilcoxon) and Kolmogorov-Smirnov tests.
4.2 Implications of foreign banks entry on the performance of the incumbent banks
In the preceding analysis, the difference in the performance of the Malaysian Islamic
banking sector between the two periods, i.e. before and after the entry of foreign banks,
will be examined. A series of parametric (t-test) and non-parametric (Mann-Whitney
(Wilcoxon) and Kolmogorov-Smirnov) tests are conducted and the results are presented
in Table V.
The results from the parametric t-test suggest that the Malaysian Islamic banking
sector exhibits lower profitability (mean ROA) in the post-entry period
(0.01012 , 0.1.27616) and it is statistically significant at the 5-percent level ( p 0.022).
The results indicate that Malaysian Islamic banks are relatively larger (LNTA) in the
ROA
Incumbent banks
De Novo banks
NIE/TA
Incumbent banks
De Novo banks
EQASS
Incumbent banks
De Novo banks
LNTA
Incumbent banks
De Novo banks
LOANS/TA
Incumbent banks
De Novo banks
LLP/TL
Incumbent banks
De Novo banks
LNDEPO
Incumbent banks
De Novo banks
Individual tests
Test statistics
0.162
0.206
1.70300
1.49787
6.39152
6.34750
28.11
14.17
2.545 *
51.76382
26.48353
55.89
47.83
26.07
29.83
27.54
18.50
0.306
6.73217
6.65819
23.89
46.50
25.39
35.00
5.830 * *
3.089 * *
0.72724
5.13787
29.07
6.83
9.02588
36.96123
3.448 * *
0.64692
2 4.87202
20.672
20.573
22.119 *
21.375
0.001 * *
0.144
23.380 * *
0.704
0.968
1.185
1.085
1.853 * *
0.952
1.903 * *
Non-parametric test
Mann-Whitney
(Wilcoxon rank-sum)
Kolmogorov-Smirnov (K-S) test
testz (Prb . z)
DistributionI DistributionDN
Mean rank
z
K-S (Prb . K-S)
Notes: Significance at: *5 and * *1 percent levels, respectively; test methodology follows among others, Aly et al. (1990), Elyasiani and Mehdian (1992),
and Isik and Hassan (2002); parametric (t-test) and non-parametric (Mann-Whitney and Kolmogorov-Smirnov) tests test the null hypothesis of equal mean
between the two models
Branch networks
Credit risk
Liquidity
Size
Capital strength
Efficiency
Profitability
Measures
Parametric test
t-test
t (Prb . t)
Mean
t
Test groups
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Foreign presence
137
Table IV.
Summary of parametric
and non-parametric tests
for incumbent
and De Novo banks
Table V.
Summary of parametric
and non-parametric tests
for pre-entry and
post-entry periods
ROA
Pre-entry period
Post-entry period
NIE/TA
Pre-entry period
Post-entry period
EQASS
Pre-entry period
Post-entry period
LNTA
Pre-entry period
Post-entry period
LOANS/TA
Pre-entry period
Post-entry period
LLP/TL
Pre-entry period
Post-entry period
LNDEPO
Pre-entry period
Post-entry period
6.21948
6.58494
1.38980
1.67933
50.67571
48.84686
6.30724
6.72363
9.46054
12.24919
0.66223
1.23616
1.27616
0.01012
2 3.115 * *
2 0.845
0.406
2 3.865 * *
2 1.385
2 1.227
2.317 *
47.73
66.63
55.22
57.98
56.68
56.29
46.35
68.21
53.63
59.81
52.50
61.12
62.92
49.10
23.072 * *
20.449
20.064
23.553 * *
21.003
21.400
22.246 *
1.563 *
0.589
0.602
1.766 * *
1.015
1.245
1.238
Notes: Significance at: *5 and * *1 percent levels, respectively; test methodology follows among others, Aly et al. (1990), Elyasiani and Mehdian (1992),
and Isik and Hassan (2002); parametric (t-test) and non-parametric (Mann-Whitney and Kolmogorov-Smirnov) tests test the null hypothesis of equal mean
between the two models
Branch networks
Credit risk
Liquidity
Size
Capital strength
Efficiency
Profitability
Individual tests
Test statistics
Non-parametric test
Mann-Whitney
(Wilcoxon rank-sum) test
Kolmogorov-Smirnov (K-S) test
z (Prb . z)
DistributionPRE DistributionPOST
Mean rank
z
K-S (Prb . K-S)
138
Measures
Parametric test
t-test
t (Prb . t)
Mean
t
Test groups
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post-entry period and it is statistically significant at the 1-percent level. In the post-entry
period, the Malaysian Islamic banking sectors operating costs (NIE/TA), level of
capitalization (EQASS), and credit risk (LLP/TL) are also found to be relatively higher
although the difference is not statistically significant. On the other hand, the Malaysian
Islamic banking sector disbursed relatively lower amount of loans (LOANS/TA) during
the post-entry period but is not statistically significant. The results from the parametric
t-test are further confirmed by the non-parametric Mann-Whitney (Wilcoxon) and
Kolmogorov-Smirnov tests.
4.3 Factors influencing the performance of Islamic banks in Malaysia
The regression results focusing on the relationship between bank profitability and the
explanatory variables are presented in Table VI based on the FEM and the REM.
The model performs reasonably well with most variables remaining stable across the
various regressions tested. The explanatory power of the models is also reasonably
high, while the F-statistics for all models is significant at the 1-percent level except for
Model 1 based on REM.
Results based on both FEM and REM indicate that size (LNTA) is positively related
to Islamic banks performance and is statistically significant at the 5-percent level or
better. Hauner (2005) offers two potential explanations for which size could have a
positive impact on bank performance. First, if it relates to market power, large banks
should pay less for their inputs. Second, there may be increasing returns to scale
through the allocation of fixed costs (e.g. research or risk management) over a higher
volume of services or from efficiency gains from a specialized workforce.
The empirical findings suggest that the level of capitalization (EQASS) is negatively
related to Islamic banks profitability and is statistically significant in Models 1 and 2 of
the REM regressions. The results are consistent with, among others, Akhigbe and
McNulty (2005), suggesting that, ceteris paribus, more profitable banks will use less
equity (more leverage) compared to its less profitable counterparts. The results indicate
that less profitable banks are involved in riskier operations and in the process tend to
hold more equity, voluntarily or involuntarily, i.e. as part of the banks deliberate efforts
to increase safety cushions and in turn decrease the cost of funds, or perhaps
responding to regulatory pressures that mandate riskier banks to have more equity.
As expected, Islamic banks performance is negatively related to credit risk (LLP/TL)
and is statistically significant at the 1-percent level based on FEM but at the
10-percent level based on REM, suggesting that Islamic banks with higher credit risk tend
to exhibit lower profitability levels. The result is in consonance with Berger and
DeYoungs (1997) bad management hypothesis which predicts that bank performance
will be impacted by non-performing loans since inefficient bank managers do not monitor
loan portfolios efficiently. The results imply that Malaysian Islamic banks should
focus more on credit risk management, which has been proven to be problematic in the
recent past. Serious banking problems have arisen from the failure of financial
institutions to recognize impaired assets and to create reserves for writing off these assets.
With regard to efficiency of managing expenses (NIE/TA), results based on REM
indicate a negative and significant impact on the profitability of Malaysian Islamic
banks. The results imply that an increase (decrease) in these expenses reduces
(increases) the profits of Islamic banks operating in Malaysia. Pasiouras and Kosmidou
(2007) and Kosmidou (2008) have also found poor management of expenses to be among
Foreign presence
139
Table VI.
Panel regression analysis
0.606699
0.484963
1.900524
4.983723 * * *
0.620471
0.497010
1.942151
5.025642 * * *
11.76193 * * *
(2.647714)
278.23382 * * *
(26.887699)
211.85000 * *
(22.403106)
248.69832 * *
(22.268318)
23.852227
(20.982470)
887.1778 * * *
(6.816864)
Model 2
28.16320 * * *
(2.683664)
20.100355
(20.774127)
24.840928 * * *
(23.390990)
0.008818
(0.044236)
0.012299
(0.170333)
211.99927 * *
(22.272290)
FEM
26.82213 * * *
(2.763024)
20.090670
(20.666786)
24.661631 * * *
(23.134260)
20.145782
(20.839282)
20.000481
(20.006537)
211.29482 * *
(22.367554)
524.8765 * *
(2.230238)
Model 1
0.289393
0.233659
5.192403 * * *
1.359679
231.18184 * *
(22.240744)
22.702060
(20.832178)
17.23570 * * *
(2.671804)
20.279539 * * *
(22.763525)
23.880163 *
(21.673262)
20.918892 * * *
(24.034560)
0.021730
(0.332678)
213.68625 * *
(22.503758)
384.2133 * *
(2.382330)
Model 1
0.300513
0.238182
1.369451
4.821281 * * *
9.185011 * *
(1.983752)
253.53527 * * *
(23.977949)
28.895512 *
(21.929539)
17.82015 * *
(2.617396)
20.291165 * * *
(22.947730)
24.006371 *
(21.773184)
20.827166 * * *
(23.628880)
0.027830
(0.424512)
214.14530 * *
(22.512807)
660.9033 * * *
(3.854137)
REM
Model 2
140
Model 3
212.08669
(21.475179)
0.306601
0.244813
1.388381
4.962138 * * *
229.77565 * *
(22.039036)
22.989458
(20.821585)
17.50034 * * *
(2.630418)
20.158237
(21.279780)
23.858162 *
(21.646464)
20.871968 * * *
(23.406887)
20.001941
(20.025682)
212.71809
(22.162131)
359.7538 * *
(2.062382)
The dependent variable is ROA calculated as net profit divided by total assets; LNTA is a proxy measure of size, calculated as a natural logarithm of total bank assets; EQASS is a measure of
capitalization, calculated as book value of shareholders equity as a fraction of total assets; LLP/TL is a measure of bank risk calculated as the ratio of total loan loss provisions divided by total loans;
NIE/TA is a proxy measure for cost, calculated as personnel expenses divided by total assets; LOANS/TA is used as a proxy measure of loans intensity, calculated as total loans divided by total assets;
LNDEPO is a proxy measure of network embeddedness, calculated as the log of total deposits; LNGDP is natural log of gross domestic products; INFL is the rate of inflation. DENOVO is a dummy
variable that takes a value of 1 for De Novo Islamic banks, 0 otherwise; POST is a dummy variable that takes a value of 1 for the post-entry period of the De Novo banks, 0 otherwise
ROAjt a b1 LNTA b2 EQASS jt b3 LLP=TL b4 NIE=TAjt b5 LOANS=TA b6 LNDEPO d7 LNGDt P d8 INFLt g9 DENOVOjt z10 POST t 1j
Notes: Significance at: *10, * *5 and * * *1 percent levels, respectively; values in parentheses are t-statistics:
Bank characteristics
LNTA
(size)
EQASS
(capital strength)
LLP/TL
(credit risk)
NIE/TA
(efficiency)
LOANS/TA
(liquidity)
LNDEPO
(networks)
Economic conditions
LNGDP
(economic condition)
INFL
(inflation rate)
Period
POST
(time)
Bank ownership
DENOVO
(type of ownership)
R2
Adjusted R 2
D.W. statistics
F-statistic
CONSTANT
Explanatory variables
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and finance products to cater for the needs of the domestic market. They may also
possess inherent economies of scale, as a direct extension of their other international
operations and so are capable of competing with the incumbent banks.
From the policy-making perspective, the opening up of the Malaysian Islamic
banking sector to foreign banks entry is deemed important in the on-going process of
improving efficiency and productivity as well as innovation. However, as competition is
expected to intensify, the smaller domestic as well as the foreign Islamic banks will
have to work harder to increase their productivity and efficiency in order to remain
competitive, profitable, and most importantly, to survive.
The intensification of competition is expected to render the issue of increasing the
efficiency, productivity, and profitability of the Malaysian Islamic banking sector as
one of the main priorities for the regulators. In this vein, the earlier studies by Berger
and Humphrey (1992), Barr and Siems (1994), and Wheelock and Wilson (1995) have
found that failing banks tend to have low cost efficiency prior to their failure and are
likely to be located far from the best practice frontiers. Within the context of the
Malaysian Islamic banking sector, the findings from this paper clearly bring forth the
importance of cost and risk management practices. Therefore, it is reasonable to
suggest that in order to remain profitable, Malaysian Islamic banks should seriously
consider minimizing their operating costs and credit risk without having to forego the
legitimacy of its operations from the syariah point of view (Sufian and Haron, 2008).
To prepare the incumbent banks for stiffer competition from the foreign fully
fledged Islamic banks, the Central Bank of Malaysia has encouraged the domestic
banking groups to establish their wholly owned Islamic banking subsidiaries. During
the period under study, apart from Maybank and Public Bank which continue to offer
Islamic banking services under the window approach, all the other local banking
groups have now incorporated Islamic banking subsidiaries. To this end, the foreign
banks have also expressed their interests to launch Islamic banking subsidiaries. This
bodes well as the findings from the study clearly suggest that size is an important and
significant determinant of Islamic bank profitability within the context of the
Malaysian Islamic banking sector. Therefore, by increasing the size of their operations,
the smaller Islamic banks, particularly the De Novo foreign Islamic banks, may benefit
from the increase in the scale of their operations.
In contrast to the window structure, where Islamic banking operations reside
within the conventional banking entity, the incorporation of the Islamic banking
subsidiary also provides opportunities to potential institutional investors, both domestic
and foreign alike, to participate in this activity through direct equity participation. The
liberalized shareholding policy in the Islamic Banking Scheme, where foreign investors
can now own up to 49 percent equity, will increase the potential to build strategic
partnerships to acquire new expertise, tap the best international talents, and develop
new value-added activities that would enhance competitiveness and stimulate greater
innovation in the industry.
The establishment of Islamic banking subsidiaries may also prove to be fruitful to
many parties concerned. As Islamic banking subsidiaries come under the governance of
the Islamic Banking Act (1983) rather than the Banking and Financial Institutions
Act (1989), it will remove most of the impediments preventing Islamic banking
windows to participate in non-traditional banking business such as wholesale and retail
trading, purchase of assets and landed properties, as well as purchases of equities via
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joint venture and portfolio investments. Malaysian Islamic banks can now underwrite
Islamic bonds and stocks in addition to providing fee-based business such as brokerage
and unit trusts.
6. Concluding remarks and directions for future research
This paper seeks to examine the determinants of the profitability of the Malaysian
Islamic banking sector during the period from 2001 to 2007. The empirical findings of
this paper suggest that overhead costs, capitalization, market share, and credit risk are
negatively related to Malaysian Islamic banks profitability. On the other hand, Islamic
banks which are larger tend to be more profitable. The empirical findings from this
paper suggest that the Malaysian Islamic banking sectors profitability has been
relatively higher in the post-entry period compared to the pre-entry period. The De Novo
Islamic banks are found to be relatively less profitable than their incumbent bank
counterparts, which could be attributed to the different levels of knowledge of the
market between the incumbent and the De Novo Islamic banks.
The empirical findings from this paper have considerable policy relevance. It could be
argued that the more profitable Islamic banks will be able to offer more new products and
services. To this end, the role of technology advancement is particularly important given
that Islamic banks with relatively more advanced technologies may have added
advantage over its peers. The continued success of the Malaysian Islamic banking sector
depends on its efficiency, profitability, and competitiveness. Furthermore, in view of the
increasing competition attributed to the more liberalized Islamic banking sector, bank
managements as well as policymakers will be more inclined to find ways to obtain the
optimal utilization of capacities as well as making the best use of their resources to ensure
that they are not wasted during the production of banking products and services.
Moreover, the ability to maximize risk-adjusted returns on investment and to sustain
stable and competitive returns are important elements in ensuring the competitiveness
of the Malaysian Islamic banking sector. Thus, from the regulatory perspective, the
performance of the Islamic banking sector will be based on their efficiency, productivity,
and profitability. Therefore, the policy direction will be focused on enhancing the
resilience and efficiency of the Islamic banking institutions with the aim of intensifying
the robustness and stability of the Islamic banking sector.
Future research could include more variables such as taxation and regulation
indicators, exchange rates as well as indicators of the quality of services offered.
Another possible extension could be the examination of differences in the determinants
of profitability between small and large or high and low profitability banks. In terms of
methodology, a statistical cost accounting and/or frontier optimization techniques such
as the non-parametric data envelopment analysis, the stochastic frontier analysis,
and/or the Malmquist productivity index approach are recommended to examine the
impact of the entry of foreign banks on the efficiency and productivity of the Malaysian
Islamic banking sector.
Notes
1. The first country with a dual banking system was the United Arab Emirates where Dubai
Islamic Bank was established in 1973 with a paid-up capital of US$14 million (Metwally,
1997).
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2. The ROA is a widely used measure of bank profitability by policymakers and bank
managements and is derived by dividing profit after tax by TA. Likewise, the ROE is also a
widely used bank profitability measure and is derived by dividing profit after tax by
shareholders equity.
3. Income of Islamic banks must not be contaminated by usury (riba). Riba the English
translation of which is usury, is prohibited in Islam and is acknowledged by all Muslims.
The prohibition of riba is clearly mentioned in the Quran, Islams holy book and the
traditions of Prophet Muhammad (sunnah). The Quran states: Believers! Do not consume
riba, doubling and redoubling [. . .] (3.130); God has made buying and selling lawful and
riba unlawful [. . .] (2:274). Thus, in the case of the Malaysian Islamic banking sector, it is
reasonable to expect the interest rate to be the profit rate.
4. In September 2003, the Central Bank of Malaysia announced the issuance of three new
Islamic banking licenses to foreign Islamic financial institutions from the Middle East under
the Islamic Banking Act (1983). Following this, the first fully fledged foreign Islamic bank,
Kuwait Finance House started operations in August 2005. The other two Islamic banks,
namely Saudi Arabia-based Al-Rajhi Bank and Qatar Islamic Bank, started operations in
2006 and early 2007, respectively. Under the Islamic Banking Act (1983), the new foreign
Islamic banks are allowed to conduct a wide range of Islamic banking business in Malaysia.
They are required to meet the minimum paid-up capital of RM10 million and will have to pay
an annual license fee of RM50,000.
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Corresponding author
Fadzlan Sufian can be contacted at: fadzlan.sufian@khazanah.com.my
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