Factors that affects the Profitability of an Islamic Banks

in GCC Countries

Table of contents
1
Chapter one: INTRODUCTION
1.1 Introduction
1.2 Background of the Study
1.3 Problem statement
1.4 Research Questions:
1.5 Research Objectives
1.7 Significance of the Study
1.8 Scope of the Study

Chapter Two :LITERATURE REVIEW

2.1 Introduction
2.2 Literature Review and Hypothesis Development

Chapter Three :RESEARCH METHODOLOGY

3.1 Introduction
3.2 Research Model and Measurement of Variables
3.3 Dependent Variable:
3.4 Independent Variable:

Chapter Four : DATA ANALYSIS AND DISCUSSION

4.1 Introduction
4.2 Data Collection
4.3 Data Analysis and discussion

Chapter Five : CONCLUSION and RECCOMUNDATION

5.1 Conclusion

REFERENCES

CHAPTER ONE
2
 INTRODUCTION

1.1 INTRODUCTION

The Cooperation Council for the Arab States of the Gulf also known as the Gulf Cooperation

Council (GCC) is a political and economic union of the Arab states bordering the Persian

Gulf and located on or near the Arabian Peninsula, namely Bahrain, Kuwait, Oman, Qatar,

Saudi Arabia, and United Arab Emirates. Jordan and Morocco have been invited to join the

council. On March 6th 2012, the six members of the GCC, likely due to Arab democratic

unrest and increased Iranian influence and pressure in the region, announced that the Gulf

Cooperation Council would be evolving from a regional bloc to a confederation. This

proposal is strongly backed by Saudi Arabia, but doubts have been raised by the other

countries. (Ariff, 2007; Olson and Zoubi, 2008; Chong and Liu, 2008).

1.1.1 Founding

Created on 25 May 1981, the original Council comprised the 630-million-acre (2,500,000

km2) Persian Gulf states of the United Arab Emirates, Bahrain, Saudi Arabia, Oman, Qatar

and Kuwait. The unified economic agreement between the countries of the Gulf Cooperation

Council was signed on 11 November 1981 in Abu Dhabi. These countries are often referred

to as The GCC States.

1.1.2 Objectives

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Among the states they are Saudi Arabia, Kuwait, Bahrain, Qatar, the United Arab Emirates,

and the Sultanate of Oman. Thus their objectives are:

1. Formulating similar regulations in various fields such as economy, finance, trade,

customs, tourism, legislation, and administration;

2. Fostering scientific and technical progress in industry, mining, agriculture, water and

animal resources;

3. Establishing scientific research centres;

4. Setting up joint ventures;

5. Unified military presence (Peninsula Shield Force)

6. Encouraging cooperation of the private sector;

7. Strengthening ties between their peoples; and

8. Establishing a common currency by 2010; However, Oman announced in December

2006 it would not be able to meet the target date. Following the announcement that

the central bank for the monetary union would be located in Riyadh and not in

the UAE, the UAE announced their withdrawal from the monetary union project in

May 2009. The name Khaleeji has been proposed as a name for this currency. If

realised, the GCC monetary union would be the largest supranational monetary union

in the world, measured by GDP of the common-currency area, after the euro area.[6]

1.2 BACKGROUND OF THE STUDY

4
Bashir and Hassan (2003) study the factors influencing the profitability of Islamic banks in

eight Middle Eastern countries for the period 19931998.GCC countries have a significant

economic dependence on oil export. Kuwait, Saudi Arabia, and Abu Dhabi in the UAE in

particular. Qatar has a large natural gas industry, Oman and Bahrain have much less

dependence on oil. All GCC countries are Islamic states with the all citizens (or almost all)

belonging to the Muslim faith. Citizens who are not Muslim probably keep that fact to

themselves as it is possible they run the risk of punishment from the state (the penalty for

apostasy is death in some or all GCC countries). Expat residents of other faiths are accepted

to varying degrees depending on the country - the UAE allows churches and other religious

buildings to operate, Saudi does not for example. Most citizens of Kuwait, Qatar, Saudi

Arabia, and UAE are Sunni Muslims but there are significant proportions of Shia (Shiite)

Muslims in all countries. Bahrain has a majority of Shi'a Muslims? Oman has a majority who

are Ibadi/Ibadhi Muslims. All GCC countries political and legal systems are based on the

Islamic religion. Sharia / Sharia'a / Shariah law is in place for the most part, and applicable to

citizens but sometimes not to expatriate residents. 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).Thus, In this study we attempt at investigating the impact of how the bank-specific

factors of profitability affects the performance of Islamic banks in GCC. This study uses

sample that is composed of Islamic banks of GCC. : It builds on Bashir and Hassans (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 Islamic

banking in the six countries constituting the Gulf Co-operation Council (GCC) namely

Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) has

5
been expanding at double-digit annual growth rates over the past decade. Today, Islamic

banks in the Gulf control a market share close to 15% of the regional banking systems

assets, and have become part of mainstream financial intermediation in this part of the world.

At the same time, Islamic banks in the GCC have also become more diverse: large pioneers

established in the 1970s co-exist with new entrants, former conventional financial

institutions recently converted into fully fledged Shariah-compliant banking entities and the

Islamic windows of still-conventional banking providers. Competition has been heating up,

forcing Islamic banks to enhance their commercial entrenchment, develop relevant business

models, strengthen their brands and reputation and provide innovative solutions to a growing

number of clients attracted by the concept of interest-free banking. Islamic banks business

models are not cast in stone. In Saudi Arabia, Bank Al-Jazira (BaJ) used to be a traditional

commercial bank, raising deposits and extending credit to both its retail and corporate

franchise. With competition heating up in the Kingdom in the field of credit, from both

established Islamic banks and the Islamic windows of conventional institutions, BaJ has

diversified into brokerage, margin lending and leveraged finance on behalf of customers. In

2006, BaJs operating income was more than five times higher than its net intermediation

income (NII), reflecting the very large revenues derived from fees and commissions,

themselves a function of BaJs appetite for brokerage and funding borrowers investments in

stocks. Al Rajhi Bank (Al Rajhi), also headquartered in Saudi Arabia, remains a mass-

market, retail-oriented Islamic bank, benefiting from the funding advantage of a very cheap

and large customer deposit base. In 2006, Al Rajhi recorded a 1% funding cost, compared to

3% on average for all the Islamic banks included in the comparative panel. Given its robust

profitability and comfortable capitalisation, Al Rajhi has been diversifying its asset

allocation into corporate lending in recent years, and building the platform for enhanced asset

management capabilities. Qatar Islamic Bank (QIB) has been following the same path to

6
seek a universal banking status built on core commercial intermediation, but augmented by

other business lines in investment banking and asset management. Dubai Islamic Bank (DIB)

has also dramatically enhanced its Islamic investment banking business through its powerful

Millennium brand established under a separate legal entity handling advisory, listing, private

equity and fund and asset management Although commercial banking in the Islamic financial

industry is expected to remain dominant, specialised and investment houses will continue to

grow, as the financing and investment needs of regional clients are getting more specific.

Given the successful evolution of the industry as a whole, newcomers (such as Masraf Al

Rayan, with its equity base in excess of US$1 billion after just 18 months of operation) will

intensify competition, forcing established players to seek opportunities in non-core, non-

traditional business lines and to explore new territories outside home markets. Kuwait

Finance House (KFH), Al Rajhi and QIB have already crossed the line by establishing

operations in the Malaysian hub, seeking a wider audience in a larger part of Muslim Asia.

Several GCC-based financiers are also sponsoring the recent foray of Islamic finance in the

UK: both European Islamic Investment Bank and Europe Finance House have Gulf banking

investors as reference shareholders. Even Shariah-compliant investment banks such as Gulf

Finance House, Arcapita Bank and Unicorn Investment Bank have been structuring

transactions outside their regional Gulf markets, both in the Western hemisphere and Asia.

(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.

7
1.3 PROBLEM STATEMENT

Islamic banking is a system of financial intermediation and its primary objective is to

provide an interest free banking practices for customers. Many studies have been done on

Islamic banking. Islamic banks operate under different principles which are based on Islamic

Sharia Law. The list of Problem statement Islamic banks in GCC

1) Rise of Islamic windows : Fully Islamic banks constitute the most visible portion of

the Islamic banking sector. Unfortunately, they face a declining market share due to increased

competition from Islamic windows. These Islamic windows accounted for 29% of the GCC

Islamic banking assets in 2008 (S&P 2010).

2) Standardization : Currently, the focus of the GCC region is to continue improving

standards. Like conventional banking, Islamic banking performance is largely dependent on

the regulatory structure. The lack of standardization of financial contracts and products across

the various banks or institutions within the same country has been a key concern. The

standards for Islamic banking operations continue to be fragmented. However, there has been

an emergence in international initiatives taken by organizations like AAOIFI and IFSB to

alleviate this problem. The rise of such institutions can help propel the growth of the industry.

3) Ethical standpoint : Under Shariah, riba is prohibited and investments are limited to

assets deemed to be ethical and legitimate. The investment can only be within industries

which are acceptable by religious standards. Vice industries, alcohol and tobacco are some

areas that do not comply with Shariah. Additionally, funding is generally provided based on
8
the investment potential and the strength of the business model, unlike conventional credit,

which is largely governed by the creditworthiness of the borrower. Due to these regulations,

Islamic banking is considered to be conservative, not speculative, as well as encourages

entrepreneurship and promotes equitable distribution.

4) Growth of sukuk: Analysts are optimistic about the increasing importance of the

bond market. This is a crucial time for Islamic finance industry as sukuk demand in the GCC

is expected to grow in the near future. Qatari sukuk as well as Saudi bonds are currently

leading the market, with U.A.E. issued sukuk close behind. According to industry players, the

recent rise of sukuk is largely due to the solid fundamentals and core values followed by the

Islamic finance industry. These are the same factors that will continue to attract potential

investors that follow strong ethical standards.

5) Global Financial Crisis: While for many GCC the effects of the crisis have been mild

compared to the rest of the world, Many GCC countries have made great strides in

strengthening their policy frameworks and robustness to shocks, stimulating healthy

economic growth, improving current account balance, foreign reserve, sovereign wealth fund

and the financial systems. But many remain highly vulnerable to a deep global downturn that

is so closely linked to oil price shocks (World Bank, 2008).

1.4 Research Questions:

1) What are the factors that affect Islamic banks of GCC countries ?

2) What are the factors have a significant influencing on Islamic banks of GCC

countries?
9
3) What are the factors have more influencing on Islamic banks of GCC countries than

others ?

4) How can Islamic windows influencing the Islamic banks of GCC countries?

5) What are the impacts of Global Financial Crisis (GFC) that happened in 2008?

1.5 Research Objectives

1. Identifying the factors that affect Islamic banks of GCC countries.

2. Determining the factors that have a significant influencing on Islamic banks of GCC

countries.

3. Indentifying the factors have more influencing on Islamic banks of GCC countries

than others.

4. Categorizing the influencing of Islamic windows on Islamic banks of GCC countries.

5. Illation the extent of impact of GFC on Islamic banks of GCC countries.

1.6 Significance of the Study

This study will identify the factors that affects profitability of Islamic banks, so is Islamic

banks can improve its profit. This research will be benefit for the bankers to control these

factors to develop their banks. Also a several studies mentioned the profitability of Islamic

banks and they just presented some variables, this study try to be comprehensive and dealing

with many main variables including GFC aggravation.

1.8 SCOPE OF THE STUDY

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This study aimed to evaluate the factors that affects the Profitability of Islamic banks in

GCC region. Islamic banks operate in all countries. In this study, Islamic banks were selected

from all countries in GCC, A major tool used to assess the performance and profitability of

any Islamic Banks are their profitability. Profitability is reflected in various indicators that

include Operating Profit Ratio (OER), Net Profit Ratio (NPR), Return on Asset (ROA),

Return on Share capital (ROCA) and Return on Total Equity (ROE). The above-mentioned

ratios indicate the relationship of profit on total income, total asset, share capital, total equity

etc. The efficiency with which an organization manages its operating expenses is highlighted

in Operating Expenses Ratio. Another major indicator of performance is capital adequacy and

is measured using Equity to Asset Ratio, calculated by dividing total equity by total assets. A

higher ratio indicates low risk and represents a higher share of ownership fund in total asset

of the bank. In addition, indicators such as profit as a percentage of customer deposits,

customer deposits as a percentage of total liabilities, and total equity as a percentage of total

assets were computed to compare between conventional banks and Islamic banks.

3.0 RESEARCH METHODOLOGY

The ordinary least square method is adopted for this study. The use of this research methodology is

reasonable and acceptable based on the availability of a number of preceding studies that taken as a

whole investigated the profitability of banking sector. Moreover for interpretation and understanding

of the results, secondary sources including; books, Journal papers and official publications will be

used right the way through this study.

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3.1 THE VARIABLES OF MEASUREMENTS

Profitability is important to the shareholders of the banks on one side and on the other dish up as spine

adjacent to unfavourable conditions which includes: losses on loans, or losses that originated due to

unforeseen and sudden changes in economic conditions. Return on assets (ROA) and return on equity

(ROE) are the largely pertained ratios used to measure financial performance (Berger, 1995; Naceur &

Goaied, 2001; Williams, 2003; Kosmidou, 2008; Siddiqui, 2008; Sufian & Habibullah, 2009). The

annual financial statements of the Islamic banking institutions were studied by using the profitability

from two dimensions (Return on Assets, Return on Equity), and explanatory variables such as Bank's

Size, Gearing Ratio, Asset management, NPLs Ratio, Capital Adequacy, and Operating Efficiency

measures for four years period.

VARIABLES

1. ROA (Return on Asset)

2. ROE (Return on Equity)

3. Bank's Size

4. Gearing Ratio

5. Asset management

6. Operating Efficiency

7. Loan

8. Deposit

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MODEL FORMULATION

To identify the internal and external factors that affects the profitability of banks in GCC countries

during the period of last 20 years, we adapt the following linear model.

Yit 0X1it 1X 2 it2X 3 it3X 4it 4X 5it 5X 6 it6X

7it Uit

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:

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