International Islamic Banking, Finance and Investment Conference

19 – 20 December 2011
Hotel Istana, Kuala Lumpur, Malaysia

PERFORMANCE OF ISLAMIC BANKING CONTRACTS IN MALAYSIA BANKING

INDUSTRY

Mior Ahmad Jafri Md Sabri and Faizil Fikri Zakaria

Universiti Tunku Abdul Rahman

ABSTRACT

This research examines the performance of Islamic banking contracts and its sensitivity
to the Islamic banks profits. These contracts differ fundamentally from the conventional
banking products where Islamic banking contracts have unique features and
mechanisms. Financing contracts divided into two types which is equity based financing
and debt based financing while deposit products apply mudharabah and wadiah
contracts. The financing contracts and mudharabah deposit contracts contribute profits
to the Islamic banks while wadiah deposit contract will incur minimal cost to the Islamic
banks. Sample of 17 Islamic banks (local and foreign banks) are studied for the period
of 2000-2010. Ordinary least square estimation is used to measure the performance of
key financial variables. These Islamic banking contracts will propose that bank’s profit is
positive and statistically significant with financing contracts and mudharabah deposit
contract against assets. This paper concludes that bai’ bithaman ajil (BBA) and alijarah
thumma albai’ (AITAB) are the most financing contracts consumed by banks’
customers. The empirical results also show that AITAB is statistically significant to the
banks profitability.
Introduction

Islamic banking contracts are the back bone to the Islamic banks’ products and services. Every
product or service must apply at least one Islamic contract to support and to validate the
transaction. This Islamic contract and transaction need to confirm to the tenet of Shariah without
involving any prohibited elements such as riba, gharar, maysir and qimar. These contracts
represent the contracts of sale, leasing, partnership, deposits, fees, suretyship, agency,
transferring of debt, gift, collateral and others.

Numerous of previous studies examined the determination of Islamic banks profits from the
perspective of main internal variables such as amount of financings, equity, consumer and short
term funds, non-interest earning assets, overhead and personnel expenses, and liabilities. Islamic
banks financings and deposits composed of various contracts applied in different magnitude.
Thus, each financing contracts and deposit contracts are expected to contribute differently to the
performance of the Islamic banks.

Evaluation of Islamic bank’s contract performance is important for all parties which are known
as bank stakeholders. In a competitive financial market, Islamic bank’s contract performance
provides signal to the bank’s management whether to improve its deposit services or financing
services or both in order to improve bank’s earnings.

Islamic banks earn profits from financing products, investment accounts and other financial
services. Consumers’ deposits are important as a source of funds and to channel it to the
investors, business firms and governments who would use these funds efficiently in productive
projects and investments. Thus, financing and deposit products would contribute to the banks’
earnings. McDonell and Rubin (1991) also agrees that sales of deposit and lending products as
one of critical success dimensions in the performance of consumer banks. However it is yet to
prove which financing contract is the most contributors to the bank’s earnings for the past ten
years and which product is the most consumed by the consumers.
Islamic banks offer various types of financing products but only several types are commonly
consumed by the consumers. Bank Negara Malaysia reported in its annual report that the most
common concepts are bai’ bithaman ajil (BBA), ijarah thumma al-bai’ (AITAB) and
murabahah. BBA commonly applies to home and property financing and AITAB applies to hire-
purchase financing. Murabahah commonly applies to asset financing, commodity financing,
contract financing, education financing, and personal financing.

The objective of this study is to examine the impact of financing contracts and deposit contracts
on the performance of Islamic banks. Different banks have different business focus. It will show
whether the contracts are statistically significance to the banks earnings.

This research paper is designed in seven sections. Section 2 defines related variables. Section 3
explains the model of Islamic banks profit. Section 4 highlights literature review on the
performance and determinants of Islamic banks profits and Islamic contracts. Section 5 discusses
the methodology used in analyzing the performance of Islamic banking contracts and its
relationship with the Islamic banks profits. Section 6 elaborates the empirical results and section
7 concludes the research paper.

Definition

Bai’Bithaman Ajil (BBA):

A sales contract that provides the buyer the benefit of a deferred payment. The deferred price of
the sale object carries an additional profit. It is an extension of the murabahah (cost plus)
contract, whereby the commodity exchanged is delivered immediately but the sale price (with
profit) is paid in installments over a long period.

Al-Ijarah Thumma Al-Bai’ (AITAB):

AITAB combines ijarah (lease) contract and bai’ (sale) contract in one trading document. Under
ijarah contract, the bank as the owner of an asset leasing out the same to its client (lessee)
against pre-determined rentals for an agreed period of time. Upon expiry of the leasing or rental
period, the lessee enters into a second contract to purchase the goods from the owner at an agreed
price.

Mudharabah:
A profit-sharing contract. It refers to an agreement between bank and depositors where the bank
can utilize the depositors’ funds for financing bank’s business and to generate profit. The profits
are distributed on a pre-agreed profit sharing ratio.

Murabahah:
Cost plus profit contract. It refers to sale of goods at a price that includes profit margin as agreed
to by both parties. Murabahah concept is similar to bai’ bithaman ajil except the financing tenor
is short term period.

Model of Islamic Bank’s Profit

Islamic bank’s profitability is the difference between income derived from investment of
depositors and shareholders funds and income attributable to depositors and other operating
expenses. This source of income is a function of financing income, dealing income and operating
income (fee and commission and other income). However, vast of the income derived from
financing income which is received from earning assets. Income attributable to depositors refers
to the returns of using depositors funds for the purpose of financing activities.

Thus, the model can be constructed as follow:

Profit = Income (Financing, Dealing, Operating) – Cost (Deposit) – Operating Expenses

Earning assets in the Islamic bank’s balance sheet composed of various financing contracts and
the common contracts are such as bai’ bithaman ajil, al-ijarah thumma al-bai’, murabahah,
musyarakah mutanaqisah, bai’ al-dayn, mudharabah, and others. These contracts are divided
into debt base financing and equity base financing. These financing incomes may derive from
sales mark up price or profit and loss sharing methods.

Deposits in Islamic bank composed of transaction deposits and investment deposits. Transaction
deposits are saving deposits and demand deposits which commonly apply wadiah and
mudharabah contracts. Investment deposits are general investment deposits and special
investment deposits that also apply mudharabah contract.

Wadiah is a contract between owner of fund (depositor) and custodian of fund (Islamic bank).
Islamic bank will act as trustee to preserve and safekeeping depositors’ funds. Returns for
wadiah contract is only in term of hibah (gift) and Islamic bank will not guarantee or promise
any returns to the depositors. However to remain competent in the dual economic systems and to
retain depositors in the banks, the Islamic banks will still pay returns to the non-mudharabah
depositors.

Mudharabah is a contract between rabbul maal (capital provider or depositor) and mudharib
(entrepreneur or Islamic bank) where Islamic bank will pool all investment funds and invest in
profitable investments. Profit from investments will be shared between depositors and Islamic
bank based on pre-agreed profit sharing ratio. However, losses from investments will be bear by
depositors. Therefore, mudharabah investment account will also contribute to the profit of
Islamic bank.

Thus, the model can be reconstructed as follow:

Profit = Income (Financing, Dealing, Operating, Muddep) – Cost (Deposit) – Operating

Expenses

Remark: Muddep is mudharabah deposits.

Literature Review

Most of previous research focused on the evaluation of Islamic banks’ performances in term of
profitability, liquidity, risk and solvency. Samad and Hassan (2000) found Bank Islam Malaysia
Berhad (BIMB) is more liquid and less risky compared to other 8 conventional banks. The
profitability ratios show the performance of Bank Islam is lagging behind the conventional bank.
The reason for lower performance may be due to less investments opportunities and high
liquidity, which means the bank is conservative in its investments. This analysis also found the
contract of mudharabah and musyarakah is not popular which may be due to lack of
knowledgeable bankers in selecting, evaluating and managing profitable projects.

Bashir (1999) and Bashir (2001) applied regression analysis in order to identify the underlying
determinants of Islamic banks performance. He found that profit of Islamic banks are generated
from overhead, customer short term funding and non-interest earning assets. The issue of
incentives in banks (agency theory) and financial intermediation theory, both predicts the quality
of bank assets is important determinant of profitability and performance of banks. McDonell and
Rubin (1991) also found that sales of deposit and lending products as one of critical factors to
success. Hassan (1999) suggested variable rate debt in conventional banks as a good example to
be an acceptable instrument for Islamic banks. This is because the variable rate debt does not
have a predetermined fixed rate of interest. Tarek and Hassan (2001) found many literatures
suggested that the acceptability of Islamic mark-up contracts is disputed because they have a
fixed return on investment for the Islamic banks. The examples of Islamic mark-up contracts are
murabaha, ijara, ijara wa-iktina and istisna. Siddiqi (1983) and Khan (1987) found that many
Islamic scholars suggested Islamic mark-up contracts should be restricted or avoided. They fear
that these mark-up contracts may open a back door to interest.

Other studies that focused on the performance of Islamic banking products found the Islamic
contract of al-Bai’ are the most contributors in terms of profit and growth to the Islamic banks in
Malaysia (Zulkifli 2007).
Nurdianawati and Asyraf (2005) found the contract of Al-Ijarah Thumma Al-Bai’ (AITAB) has
grown its performance due to high demand from customers since its inception more than 10
years ago. AITAB offers several advantages to the banks which are low credit risk and high rate
of return. Customers also gain benefits of fixed rate financing compared to other financing
products.

Mudharabah financing contract has less offering from the Islamic banks due to its distinctive
features such as no participation rights in business decision making by bank (Ghazali 1955), lack
of adequate legal safeguards to the financier (Ahmad 1993), misleading factors whether
mudharabah financing is a pure loan to the borrower or as equity financing to the bank (Bacha
1996), and uncertainty to determine the ex post rate of profit and the return of money advanced
to firm (Zubair Hassan 2001). Zubair Hassan also argued that mudharabah deposit mostly
financed stock markets or trade financing and lack of long term business financing. Rachmawati
and Syamsulhakim (2004) found the size of mudharaba deposits in Indonesia are influenced by
the profit sharing rate and number of branch offices of Islamic commercial banks.

Contract of bai’ bithaman ajil has raised many issues in implementing the contract. According to
Saiful Azhar (1999), the role of the bank as a trader, namely the buyer of property from the
vendor and seller of the same property to the customer, is somewhat clouded and misconstrued.
This is because a sale and purchase agreement between the bank and the vendor or developer is
relatively absent. The role of the Islamic bank as a financier is most revealing (rather than a
trader) under this state of affairs. If the Islamic bank desires to embrace the spirit of al-bai’, as
the Quran has rightfully intended, it must hold the risk of possession of the property before
resale. The Islamic bank should venture into the construction business itself rather than assuming
the role of a trader as direct production activity produces higher profit.
Methodology

Sample of study covers financing contracts of 17 Islamic banks (local and foreign) incorporated
in Malaysia. The financial data will be taken from the financial statements of the banks’ annual
reports. The period of study would cover 10 financial years from 2000 to 2010. This period and
samples of study is expected to provide sufficient data to run the regression analysis. Table
below shows the full list of licensed Islamic banks in Malaysia announced by the Central Bank
of Malaysia (http://www.bnm.gov.my/index.php).

Table 1: List of Licensed Islamic Banks in Malaysia

No. Name Owneship

1. Affin Islamic Bank Berhad Local
2. Al Rajhi Banking and Investment Corporation (Malaysia) Foreign
Berhad
3. Alliance Islamic Bank Berhad Local
4. AmIslamic Bank Berhad Local
5. Asian Finance Bank Berhad Foreign
6. Bank Islam Malaysia Berhad Local
7. Bank Muamalat Malaysia Berhad Local
8. CIMB Islamic Bank Berhad Local
9. EONCAP Islamic Bank Berhad Local
10. Hong Leong Islamic Bank Berhad Local
11. HSBC Amanah Malaysia Berhad Foreign
12. Kuwait Finance House (Malaysia) Berhad Foreign
13. Maybank Islamic Berhad Local
14. OCBC Al-Amin Bank Berhad Foreign
15. Public Islamic Bank Berhad Local
16. RHB Islamic Bank Berhad Local
17. Standard Chartered Saadiq Berhad Foreign

This research examines the performance of Islamic banking contracts and its sensitivity to the
Islamic banks profits. In evaluating financing performance of Islamic banks, financial data of
bank sizes, consumer deposits and financing contracts are collected from the banks’ annual
reports.
Regression analysis is applied to identify the contribution of the Islamic banking contracts to the
Islamic banks earnings. The dependent variable is profit before tax and zakat and the
independent variables composed of deposits contracts and financing contracts. Deposit contracts
are divided into two main categories which are non-mudharabah deposit and mudharabah
deposit. Financing contracts are divided into four main categories which are bai’ bithaman ajil,
al-ijarah thumma al-bai’, murabahah and other financing. The other financing includes
tawarruq, musyarakah mutanaqisah, musyarakah, mudharabah, bai’ al-dayn, bai’ al-inah, qard
hassan and istisna. These financing contracts represent smaller size and offered by selected
banks.

In order to determine reliability of the performance measure, ordinary least square estimation
will be used to identify the beta and the t-values. This linear regression is widely used in the
researches and produces good results (Bourke, 1989). The measure of the total exposure of the
bank’s earnings is by estimating the following linear equation:

Eit = αi + βiXi + eit (1)

Ebt is the earnings of bank i in period t, where it is derived from profit before tax and zakat over
total assets (PBTZ/TA). Xi is the bank variables that include financing contracts and consumer
deposits. αi is a constant, βi is a coefficient and eit is an error term. Equation (1) is a factor model
that allows measurement of factor sensitivities. A potential problem in estimating such a four -
factor model arises from the possibility that the financing products may be correlated or jointly
influenced by some external shocks.

PBTZ/TA is measured to reflect the Islamic bank’s ability to generate higher profits by
diversifying bank’s assets. Bank with large assets would produce higher profits and offer various
financial services at lower costs, thus positive correlation between PBTZ/TA and explanatory
variables in equation (1) will give support to the efficient structure hypothesis (Smirlock, 1985).

Internal bank variables used in the linear equation are as follows:

Ratio of financing contracts to total assets is expected to have a positive correlation with bank
earnings. Bank financing contracts are part of sources to bank revenue, thus financing contracts
would affect the bank earnings positively. Previous researches also support the findings that ratio
of loans to total assets is positively correlated with bank earnings (Demirguc-Kunt and Huizinga,
1999).

Consumer deposits consist of non-mudharabah deposits and mudharabah deposits. These

deposits are liabilities to the bank and holding this liquidity is an expense to the bank. Thus, the
ratio of non-mudharabah deposits to total assets is expected to show negative correlation with
bank profitability. Returns for non-mudharabah deposits are in term of gift (hibah), but the
Islamic banks are not obliged to pay the returns to depositors. However, returns from
mudharabah deposits will be shared between depositors and Islamic bank. Thus, the ratio of
mudharabah deposits to total assets is expected to show positive correlation with bank
profitability.

A brief description of dependent variable and independent variables are listed in following table.

Table 2: Variable Definitions

Symbol Definition Sample Mean

PBTZTA Ratio of Profit Before Tax and 1.0553
Zakat to Total Asset
BBATA Ratio of Bai’ Bithaman Ajil to 24.4474
Total Asset
AITABTA Ratio of Al-Ijarah Thumma 18.7884
Al-Bai’ to Total Asset
MRBHTA Ratio of Murabahah to Total 6.2056
Asset
OTFINTA Ratio of Other Financing to 8.2302
Total Asset
DEPNMTA Ratio of Deposit of Non- 27.6560
Mudharabah to Total Asset
DEPMTA Ratio of Deposit of 41.4349
Mudhrabah to Total Asset
Empirical Results

Table 3 shows results of regression analysis on the Islamic banks’ variables. The purpose of this
analysis is to identify bank variables that affect the performance of Islamic banking. Regression
analysis will show the relationship between profitability and bank variables. This relationship
will also identify the important variables that affect bank’s profitability. Sample of study
involves 107 observations of Islamic banks. This analysis is based on White’s Heteroscedasticity
adjusted Standard Errors. This method is used to confirm that the coefficients are heteroscedastic
(White 1980).

Table 3: Ordinary Least Squares Estimation

Based on White's Heteroscedasticity adjusted S.E.'s
******************************************************************************
Dependent variable is PBTZTA
107 observations used for estimation from 1 to 107
******************************************************************************
Regressor Coefficient Standard Error T-Ratio [Prob]
INPT 1.1676 0.78295 1.4913 [0.139]
BBATA -0.0084337 0.012448 -0.67752 [0.500]
AITABTA 0.029809 0.0053371 5.5854 [0.000]
MRBHTA -0.022152 0.014922 -1.4845 [0.141]
OTFINTA -0.0099720 0.014597 -0.68316 [0.496]
DEPNMTA -0.0068408 0.010948 -0.62487 [0.533]
DEPMTA -0.0013879 0.0068293 -0.20322 [0.839]
******************************************************************************

The regression of all key financial variables of Islamic banking contracts shows only two
financial variables are significantly difference that are AITABTA (significance at 1% level) and
MRBHTA (significance at 20 percent level). The result reveals AITABTA has positive
correlation with the profitability and constant with the theory where financing contract
contributes positively to the profits. According to Nurdianawati and Asyraf (2006), AITAB
contract has continuously contributed to the growth of Islamic banks due to high demand from
customers.
The regression result indicates that the change in Islamic banks profits is influenced by the
change in AITAB financing. The coefficient also explains that a 1 unit increase in AITAB
financing will improve 0.03 (thousand) in Islamic bank profit.

AITAB is one of ijarah contract where ijarah is defined as a sale of the use of other’s asset or
property. It is a contract between two parties, lessor and lessee, where lessee has the right to use
the asset against a specified rent or lease from the asset’s owner. AITAB is defined as a leasing
contract with an option that the lessee will buy the asset at the end of leasing period. Thus,
AITAB involves two different contracts which are contract of leasing at the beginning of leasing
period and contract of sale at the end of leasing period. Contract of leasing involves a tangible
asset and the lessor must be the owner of the asset. This indicates that the lessor will retain the
title of the asset during the period of leasing and the lessee has the rights to use the asset. Upon
full settlement of the leasing, the title of the asset is transferred to the lessee through the contract
of sale. Other conditions include the leasing duration and the leasing fees are agreed between the
two parties in advance. Thus, AITAB is the process of converting ijarah contract into a bai’
contract and it is not a conditional sale (Abdul Ghaffar 2010). This will allow the customer to
own the asset that he cannot afford to buy on a cash basis but will buy it in future date when
rental payments are fully settled through out the leasing period. Other advantages of AITAB are
the profit margin is based on market value, the penalty for late payment will be charged 1% by
the Islamic banks and this facility is applicable to all types of goods, movable or immovable,
including real property (Seif I. and N. Irwani 2007). Therefore, AITAB is practically applied in
various Islamic banking products such as asset financing, contract financing, industrial hire
purchase, leasing, plant and machinery financing, project financing, syndicated financing,
automobile financing and letter of credit (www.mifc.com).

Thus, this research shows that AITAB is significantly and positively correlated to the profits and
is due to low risk faced by the Islamic bank such as tangible asset involved or asset backed
financing and pre-agreed leasing fees. High demand from customers is due to transparent profit
margin charged by the Islamic bank which is based on market value and low penalty charges
compared to 8% charged by conventional banks. This attractive features also support by other
research which is low risk involved, high return on the investment, tax benefits derived,
favorable features based on asset-backed transactions, its relative liquidity, and possibility of
floating rate base, whereas other Islamic financing generally adopt a fixed rate basis
(Nurdianawati and Asyraf 2006).

This study also reveals MRBHTA has negative correlation with the profit and it is not constant
with the theory where financing contract contributes positively to the profits. However it is only
significant at 20 percent level. This result is also against previous research finding where the
contract of bai’ murabahah which is one of the concept under the contract of al-bai’ are the
biggest contributor in terms of growth and profit to the Islamic financial institutions in Malaysia
(Zulkifli 2007). The negative correlation may also due to lack of murabahah financing offered
by six Islamic banks in Malaysia.

The regression result indicates that the change in Islamic banks profits is also influenced by the
change in murabahah financing. The coefficient explains that a 1 unit decrease in murabahah
financing will improve 0.02 (thousand) in Islamic bank profit.

Murabahah financing is a sales contract based on markup price or the asset is sold at a cost price
plus agreed profits. Both buyer and seller will know the cost price and profit. Customer can make
repayment on asset either in a lump sum or by installment on deferred basis. Murabahah
financing commonly applied for short term financing such as cash line facility, commodity
murabahah financing, contract financing, education financing, personal financing, revolving
credit facility, working capital financing and trade finance facilities.

Other results show that BBATA and OTFINTA have negative correlation with profits and it is
not constant with previous studies. DEPNMTA and DEPMTA also have negative correlation
with profit and it is constant with previous studies where deposits are expense to the bank’s
profitability. However, all these four variables are not statistically significant.
Conclusion

This research has attempted to study the contribution of financing contracts and deposit contracts
to the profitability of Islamic banks in Malaysia. Four major types of financing contracts and two
major deposit contracts stated in Islamic banks balance sheets concluded that AITAB is
significantly influenced the banks profits. The positive correlation suggests that any increase in
AITAB financing will also increase the profitability of Islamic banks.

It is suggested that Islamic banks should further develop a more competitive and innovative
products that will better suit and apply to the Islamic banking contracts. Further, the Islamic
banks must fully utilize the benefit of mudharabah deposits as long term project financing and
investment by explaining and educating depositors on the possible risks and returns facing by
them.

This research also need to be acknowledged that some limitation exist in the samples and the
period of study. Some Islamic banks started operations after year 2000. The number of
observation will not same with other Islamic banks that started their operation since before year
2000. Two local Islamic banks and four new foreign Islamic banks do not offer murabahah
financing contracts to customers.

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