Determinants of Banks Profitability - Example

Finance and Accounting Table of Contents Introduction 3 Islamic Banking Vs Conventional Banking 4 Determinants of Banks’ Profitability  8 Conclusion14 Reference list 16 Introduction This first portion of the study has been prepared for understanding and comparing the performance of the Islamic and conventional banks in terms of efficiency, risk management and profitability. It would be starting with an insight into the growth of Islamic banks during nineties followed by the comparison between the two banks. It has been found that the Islamic banks are much more efficient than the Conventional banks. Their profit and loss sharing concept and prohibition of interest transactions of the Islamic banks have facilitated the overall economy of the industry during the crisis period. The most renowned approaches for explaining the banking function process are mainly the production and intermediation approaches. In the production approach, the banking activities associated with the production of services available to the borrowers and depositors are described. The intermediation approach, on the other hand, harmonizes the production approach. It mainly views banks as intermediaries of various financial services and assumes them to collect funds and convert them into loans or other assets. Both Conventional banks and Islamic banks act as intermediaries. The present financial crisis has shed uncertainties in the appropriate functioning of conventional banking and has increased the importance of Islamic banking (Noor and Ahmad, 2010). Growth of Islamic Banking Industry The Islamic banking industry witnessed a rapid growth and sustainable expansion during the nineties. There were two different approaches for expansion. Firstly, the Islamic financial institutions and banks were introduced in different countries involving various non-Muslim countries also. Presently, the number of such financial institutions and banks has increased even greater than hundred. The second attempt was converting the entire financial system in the Muslim countries to adapt Islamic principles (Iqbal, 2001). The Muslim countries included Iran, Sudan, Pakistan and many more. The performance of these banks have been assessed and evaluated during this period and findings reveal that they have performed fairly. . The operating revenue had increased by 11.2 percent within 1990 to 1994. In the second half of the nineties, the operating revenue increased by 3.7 percent (Iqbal, 2001). Thus, Islamic banks had a significant growth in terms of profitability during the nineties in all aspects. The second part of the paper elaborates the determinants of the Islamic banks and the conventional banks which affects its overall profitability. For conventional banks, the main factors that affected the profitability are the internal and the external factors. Whereas, for the Islamic banks the main factors that affected the profitability of the banks are the ratios which showed both positive and negative relation with profitability. Islamic Banking Vs Conventional Banking Comparison Olson and Zoubi’s studies related to conventional banking state that, the banks earn profits by buying transaction deposits from depositors at very low interest rate, followed by selling them at high interest rate to the borrowers, on the basis of competitive advantage related to information gathering and risk underwriting (Olson and Zoubi, 2008). The conventional bank earns profit from the difference between the interest rate charged to the borrowers and the rate given to the depositors. The Islamic banking also performs the function of intermediary. But the main difference in their functioning is that they generally do not receive any pre determined rate of interest from the borrowers and at the same time do not pay any predetermined rate of interest to the depositors (Olson and Zoubi, 2008). The profit is earned on the basis of profit sharing agreements made with the depositors and the borrowers. There is allowance of fee based service in this type of banking service, which is similar to some extent to the conventional banks. The theories related to Islamic banking have been summarised well by Olson and Zoubi. However the journal of Bader, et al (2008) suggests that the Islamic banking is considered as a distinct banking stream, which prohibits the interest transaction and replaces it with the profit sharing agreements (Bader, et al., 2008). According to this study, the profit share is dependent on the risk participation of different parties. Presently, there has been an increase of academic research on the Islamic banking. This is mainly because of the fast growth in the Islamic banking industry. In last three decades, these institutions have expanded their operations all over the world at significant pace. According to one of the studies in International Monetary Fund (2005), there has been a significant increase in the number of Islamic banks, from 75 banks in the year 1975 to more than 300 banks in the year 2005. Total asset value is increasing 15 percent every year, which is three times the growth rate of the conventional banks. However, three topmost conventional banks had very high asset value in the year 2005: Citi Group in USA had asset value of US $ 1484 billion; Mizuho Financial Group in Japan had an asset value of US $ 1296 billion and UBS in Switzerland had an asset value of US $ 1533 billion. Moreover, the bank of America which ranks tenth possesses an asset value of US $ 1110 billion (Bader, et al., 2008). It is four times higher than the asset value of all the Islamic financial institutions. If the banks perform their functions efficiently then it would lead to increased profitability, higher funds getting intermediated, high prices and quality services for the consumers. If some amount of ‘efficiency saving’ is utilized for improvement of the capital buffers, which absorb the risk, then it would increase the soundness and safety of the banks. The efficiency of the banks helps in improving the overall economy having a positive impact on the society as well. The efficiency of the banks get influenced by a number of factors existing in the environment like, size, quality of input, output, age, characteristics, management characteristics and changes in the rules and regulations. Conversely inefficiency in the financial intermediaries might lead to additional danger, in the tax payer financed industry resulting in substantial losses. The liberalization in financial markets globally has increased the utilization of advanced technology in the banking industry. This has given competitive pressure on the banking firms in the domestic as well as the international markets all over the world. This pressure is important for the banks originating in emerging markets because they comprise of the main financial intermediaries for channelizing the investments and savings. If the banks perform their function efficiently, then the competitive advantage gets enhanced. Thus the journal provided by Bader, et al (2008) has helped in summarising the increase in the demand of Islamic banking over Conventional banking. However, in this context, Bader, et al (2008) have stated that the conventional banks have a number of advantages over the Islamic banks. These banks are operating from a long period of time and have huge experience in this field; they allow interest transactions, which act as the strongest source of revenue; do not prefer sharing losses with the clients and demands for guaranteed collaterals in maximum transactions. This facilitates them in enjoying high capital spread widely along with more advanced technologies. They can easily enter the Islamic banking market. There have been many researches related to the efficiency of the conventional and Islamic banking streams. In last few years, there have been a number of changes in the functioning of both the banking streams. The present scenario reflects that a large number of big international conventional banks are offering Islamic banking services to the customers in order to compete with the Islamic banks. The Islamic banks have increased in number and they are also competing among themselves to achieve success in the industry. The practice of Islamic banking is spreading rapidly and because of the establishment of a large number of Islamic banking entities, new rules, regulations, accounting standards and policies are being designed in order to accommodate the changes. According to Beck, Demirgüç-Kunt, and Merrouche (2010), it has been found that Islamic banks are much more efficient as compared to the conventional banks. However, this issue is highly controversial and requires investigation in the differences between their functioning. One of the most unique features of the Islamic banking is its characteristics related to profit & loss sharing paradigm. In practice, the functioning of Islamic banking is not highly different from the conventional banking excepting its profit and loss sharing concept. Chong and Liu (2009) have mentioned in their journal that the rapid growth of Islamic banking industry is highly driven by Islamic renaissance because of the advantages received from the profit and loss sharing paradigm. It has been suggested that the Islamic banks must be subjected to strict rules and regulations like their western counterparts. Thus Chong and Liu have helped in focussing on another important aspect of Islamic banking in terms of the growth in the industry. There has been significant increase in the literature on Islamic banking revealing their role on the Islamic finance. Most of the literatures contain comparison between functioning of Islamic banks and Commercial banks. Islamic banking, also termed as Shari’ah-compliant banking deals with the use of those financial products and services, which belong to laws and religious practices of Islam (Bassens, Derudder, and Witlox, 2011). As already mentioned, the Islamic financial services prohibit the receipt and payment of interest at a predetermined rate. The profit and loss sharing arrangement, buying and reselling of the products and services, and providing services for fees are the basis of contracts in Islamic banking. Cihak and Hessee (2008) have clearly mentioned in their study that while considering the profit and loss sharing contract in Islamic banking, the actual rate of return on financial assets remains unknown before undertaking such transaction. In case of buying and reselling transactions, one mark-up is always decided based on the benchmark rate of return. Islamic finance has become one of the most rapid growing segments in the international financial industry, where its operation has become so important that it cannot be ignored. There are various factors responsible for this rapid growth of Islamic banking industry. They are: a) High demand for the Shariah-compliant products in most of the Islamic countries; b) advancement in the regulatory and legal frameworks for Islamic finance; c) increasing demand from the conventional investors in the market; d) ability of Islamic banking industry to produce a large number of financial instruments, which would meet the needs and demands of corporate as well as individual investors. In comparison to this, there have been many arguments, which claim that the loss, which the conventional banks suffer during the crisis period, is because of the lack of exposure in the assets. It is the risk sharing and asset based nature of the Islamic finance, which has shielded this banking industry from the effect of crisis period. Shafique, Hussain and Hassan’s study have stated that the comparison between the performances of Islamic banks and Conventional banks indicate better performance of the Islamic banks, whereas the Conventional banks have incurred huge losses in United States and Europe due to global crisis (Shafique, Hussain and Hassan, 2012). In order to assess the effect of global crisis on both the sectors, it is important to assess the performance of both the banking industries in various aspects during the crisis period. Hasan and Dridi (2010) have helped in assessing the profitability of both the banks between the time periods of 2008 to 2009. In respect of profitability, Islamic banks have performed better than Conventional banks in the year 2008. In 2009, the growth of Islamic banks in assets and credit started becoming higher than the conventional banks in almost all countries excepting United Arab Emirates. According to the rating of financial institutions by the rating agencies, the change in the risk assessment of Islamic banking has been much better as compared to the conventional banking (Hasan and Dridi, 2010). The business model of Islamic banking helped in shielding the adverse effect of crises period on the industry. Mostly Islamic banks play very similar roles like the conventional banks. They help in addressing to the asymmetric information problem. The banking model reduces the overall transaction cost and facilitates in the diversification process for small investors and savers. While carrying on their business, the Islamic banks manage and reduce the risk associated with asymmetric information problems. However, the main difference in the operations of Islamic banks and conventional banks is that the Islamic banks perform their operations in compliance with the rules and regulations of Shariah (which is the legal code in Islam). The concept of Islamic banking is justice by means of its risk sharing method. The Islamic banking and finance (IBF) includes high moral and ethical values. Khan (2010) has argued that the Islamic banking is much more economically efficient as compared to Conventional banking. The Islamic banks promote higher justice and economic equity in comparison to conventional banking. The ‘interest-free banking’ concept of Islamic banking has driven the industry during financial crisis period. Research has also been done on the reason behind the conventional investors getting attracted to the Islamic financial instruments. Comparison between Malaysian Islamic & Conventional security prices and their responses to the macro economical factors suggest that the Islamic bond and conventional bond as well as their equity prices are driven by some common factors. However, results reveal that in past few years the Islamic banks have also started responding to the financial and economic shocks, similar to the conventional banks (Krasicka and Nowak, 2012). This suggests that the gap between the conventional and Islamic financial and banking practices is shrinking. Thus Krasicka and Nowak (2012) have helped in finding out that there is a gradual shrinkage in gap between the two banking systems. Mohamad, Hasan and Bader (2009) have suggested in his journal that there is no significant difference in the overall efficiency result of the Islamic and conventional banks. It suggests that there remains scope for both the banking system to improve in respect of profit maximization and cost minimization. However, most of the results are in favour of Islamic banking system because they possess high capital and good liquidity position (Jaffar and Manarvi, 2011; Said, 2012). Determinants of Banks’ Profitability  Determinants of the Conventional Banks Scott and Arias (2011) has identified that the banking industry plays a crucial role in the economic development of the country. It has made itself strong enough over decades to generate profit and contribute to the betterment of the mass. Researches carried by other researchers like Berger and Deyoung (1998 cited in Scott and Arias, 2011) have brought to highlight that banking industry in United States has extended their branches nationally and also internationally rapidly within few years. The banking system has developed over the decade from fewer branches nationwide to numerous numbers of branches. It has experienced potential diseconomies over the period, due to many reasons. The main reasons being the agency cost which is associated with monitoring of junior managers in the geographical expansions. Innovations in telecommunication and information processing will lessen the agency costs by progressing on the ability of the senior managers, who are located at organizational headquarters. They have primary duty of monitoring and communicating with the distant staffs and the subsidiaries (Scott and Arias, 2011). As identified by Kosmidou, et al (2003), the main reason for inefficiency of Ukrainian banking sector roots from the Soviet banking system. The increase in number of banks in Ukraine has been rapid from 1991, since the government possessed no barrier for the entry of the new banks. But the condition of the banks was not good due to the Soviet banking system that they followed. During the end of 2009, 179 banks were licensed, but the operation thereafter was not so significant. The condition became better when the three banks were nationalized. Thus, the typical Soviet banking system affected the profitability of the banks (Kosmidou et al., 2003). According to Gart (1998), the banking sector is an important source of financing for most of the businesses. Good financial performance leads to betterment of the organizations. There are various external and internal banking characteristics which drew the difference between the determinants of profitability in both the banks. As identified by him, the determinants of profitability of banking system can be explained through the external and the internal variables. The internal factors are under control of the bank management and the external factors are the macro-economic environment that affects the performance of the bank. Short and Bourke has studied on the bank profitability (Gart, 1998). The results showed the following internal and external factors that affect the profitability of the banks (Kosmidou et al., 2003). Internal factors Size of the bank As identified by Liu and Wilson (2000), the size of the firm has an indifferent impact on the profitability of the banks. In a research of the European banks, which was done taking the period from 1992 to1998, Goddard (2000 cited in Liu and Wilson, 2010) found that there lies a relationship between the size of the bank and its profitability. Smirlock (2001 cited in Liu and Wilson, 2010) had proved that there is a significant positive impact of size of the bank on the profitability of the bank. He has also found out the fact that the positive influence is due to the lowering of the capital cost for the big banks (Liu and Wilson, 2010). But despite of the positive responses that are obtained by the above researchers, Liu and Wilson (2010) have identified that there is no evidence that whether increase in size of the bank benefits the bank by economies of scale to banks (Liu and Wilson, 2010). Cost Liu and Wilson (2010) have figured out that the operating cost of the bank has negative correlation with the profitability of the bank. The level of operating expenses is observed to be the key indicator efficiency of the management of the bank efficiency. He after extensive research that included several European countries concluded that the operating costs do have a negative impact on the profit despite of the positive effect on the net interest margins. The addition of the expenses of the bank in the profitability is supported by many researchers who find link between the profitability of the bank and their expense management (Liu and Wilson, 2010). Liquidity Kosmidou, et al (2003) have identified that liquidity insufficiency is the most important factor that leads to the failure of banks. The liquid assets have opportunity cost, which gives higher return when it is kept in hold. He has also examined that a major positive relation between the liquidity of the bank and the profitability. In the phase of instability, the banks may prefer in increasing the cash holdings for mitigating the risk (Kosmidou et al., 2003). Capital According to Kosmidou, et al. (2003), the banks with significant higher levels of fund have performed better than the banks with low capital. He has made a claim that there is a positive relation between higher capital and profitability among European Union banks. His have also traced out the positive impact of the level of equity on the profitability. Thus he have supported the finding of the positive relationship between the bank’s earning and the capital/asset ratio (Kosmidou et al., 2003). Asset Quality According to Ponce (2012), there is a direct relationship between the profitability of the bank and their asset in the balance sheet. Poor credit quality possesses a negative impact on the profitability of the bank. He identified that the relationship is because of increase in the doubtful assets that does not accumulate to increase the income. There is a requirement for the bank for allocating the gross profit margin, which covers the expected credit loss, thus it will lower the profitability (Ponce, 2012). External Factors The external factors like the macro-economic factors also affect the profitability of the banks. The factors are as follows: Inflation Ponce (2012) has regarded these as the most important determinant of profitability of the bank. He has identified the fact that profitability of the bank will only get affected by the inflation if the inflation rate moves faster than the operating expense. Thus, he said that the effect of inflation is dependent on the macroeconomic stability. His studies have proved that the relation between the performance of the bank and inflation rate is dependent on the ability of the management for predicting inflation. The correct prediction of inflation and interest rates by the mangers will help the management in collecting good amount of revenue which is higher than the cost (Ponce, 2012). Exchange rate Kosmidou (2008) have stated that there is no effect of the exchange rates on the profitability of the banks in the European Nations. But the same is not for the banks in Ukraine. The Ukrainian banks are operating in such an environment, where the income can be extracted from the foreign exchange transactions due to the lack of transparency in pricing of financial products (Kosmidou, 2008). Industry Characteristics Davydenko (2010) have concentrated on the monopolistic nature of the banks in earning profit. The studies suggest that the increase in the market lead to the monopolistic profits. The banks which are in highly concentrated market tend to earn profit by monopoly power. He have also pointed out the fact that concentration tends to reduce the profits of the foreign competitors by restricting their entry (Davydenko, 2010). Domestic VS Foreign ownership Kosmidou (2008), have pointed out the fact that foreign banks are less cost efficient. The domestic banks earn more profit than the foreign banks. He has proved the fact that the domestic banks have outperformed the foreign banks in regard to profit. Bonin, Hasan and Wachtel (2007 cited in Kosmidou, 2008) have concluded that foreign owned banks are more cost efficient than the domestic banks. They have identified the need of foreign ownership for the development of the local banks. The foreign ownership of the local banks will lead to disciplining of the work environment of the bank and boosting the efficiency of the employee of the banks. The overall efficiency of the domestic banks can be increased by the foreign ownership of the bank. The foreign banks acquired the local agents for maximizing their profit and provided control on them (Kosmidou, 2008). Market share According to Halkos and Salamouris (2004), the banks which have larger market shares are more profitable than the smaller counterparts. The banks with well differentiated products and larger market share exercises market power and they also earn higher profits (Halkos and Salamouris, 2004). Stock Market The stock market finance also affects the profitability of the bank. Halkos and Salamouris (2004) have argued on the fact that development of the stock market level will increase the profitability of the bank. The reason behind the increase is that the development of stock market permits the firms to be more capitalized therefore; there is remarkable reduction in the risk of loan default. Higher the level of development of the stock market more information about the publicly traded firms is available, which helps the banks for evaluation of the firm for the credit risks. More the development of the stock market more is the availability of the information and thus there is pool of potential borrowers, who are interested in investing the firm. These help the banks to identify the firm better and monitor the loans that are taken by them. Thus, there is also an increase in the volume of business for the banks, which leads to profitability (Halkos and Salamouris, 2004). Determinants of the Islamic Banks Ali, et al. (2012) has identified that there is a steady expansion of Islamic banks during the period of 1980s and 1990s in the Middle East. With its networks across 60 countries and with revenue of $200 billion, the Islamic banks have been playing an important role in the development of the banking sector globally. There are seven characteristics of the bank that are used as the internal determinants of the bank’s performance. These are the measures that are mostly used for understanding the factors that underline the return on assets and net margin. “They include fund source management (CSTFTA), funds use management (OVRHEAD and NIEATA), capital and liquidity ratios (EQTA and LOANTA), risk (LATA) and a fake variable for ownership (FRGN)” (Ali et al., 2012). All the determinants except the risk variable are interacted with the GDP for capturing the impact of GDP on bank’s performance. The earlier studies conducted by Ali, et al. (20120 regarding the determinants of profitability of the banks have found strong relationship between the profitability and EQTA. These identify the fact that profitable banks are well capitalized and enjoy cheap access to source of funds, which increases the profitability of the bank. The researchers have also found positive relationship between the ratio of bank loan to total asset (LOANTA) and the profitability. The bank loans are the main resource of revenue and it affects the profit positively. Hassan (n.d) has pointed out that the loans of the Islamic banks are in the form of the profit and loss and as a result it may get affected during the time of financial crisis. The Islamic banks earnings come from the non-interest activities. Thus, the ratio of non-interest assets to total assets (NIEATA) is predicted to affect profitability of the bank positively. The ratio of the consumer and short-term funding to total assets (CSTFTA) is liquidity ratio is obtained from the liability side of the balance sheet. It consists of the current deposits, investment deposits and saving deposits. The liquidity holdings tend to present itself as the expense to the bank thus, the coefficient of the variable is predicted to be negative (Hassan, n.d). Ika and Abdullah (2011) have stated that the operation in the Islamic banks is identified by the high scale of financial risks. The Islamic banks undertake risky operations for generating comparable returns for their customers, when there is absence of guaranteed returns on the deposits. The ratio of total liabilities to the total assets (LATA) is taken as the alternate for risk calculation. The ratio indicates greater leverage or lower capital. With the help of LATA, there is greater understanding of risk that the bank takes when they are opting for higher returns. When the bank decides to take capital risk, the return equity as well as the leverage multipliers is higher (Ika and Abdullah, 2011). During the study of Ika and Abdullah (2011), LATA is taken to be positively linked with the bank’s performance (Bashir, 2003). The absence of insurance deposit leads to higher risk taking, which exposes the bank to insolvency (Ika and Abdullah, 2011). Thus, the LATA coefficient can be negative. The ratio of the overhead to total assets (OVRHD) helps in providing information on the variations in the bank cost in assistance with the banking system. It indicates the total amount of salaries and wages. According to the study of Almarazi (2012) overhead is predicted to have negative effect on the performance because the proficient banks are expected for operating at a much lower cost. The determinant of foreign ownership (FRGN) is predicted to impact profitability positively as it indicates the benefits of the foreign banks from the tax breaks (Almarazi, 2012). Conclusion Both Islamic banking and Conventional banking performs the function of intermediaries. The Islamic banking industry has seen significant growth during the nineties. These banks have gained huge importance during the period of global crisis. Although, the conventional banks have several advantages over Islamic banks, as they are performing their operations from a long period of time and possess good experience in this particular field, but most of the researches have suggested that the Islamic banks are much more efficient than the Conventional banks. Their profit and loss sharing concept and prohibition of interest transactions have facilitated the overall economy of the industry during the crisis period. However, the gap between both the banking industries is shrinking gradually as the Islamic banks have also started responding to the global financial crisis. Both the banking systems have scope of improvement in operational activities associated with cost minimization and profit maximization. The determinants affecting Conventional banks tend to find positive relationship with the profitability of the banks. The studies have also traced out the positive impact of the level of equity and the stock market movements to have positive effect on the profitability. The determinants of the Islamic banks which are identified by the different ratios tend to find a negative correlation with profitability. The LATA coefficient is coming to be negatively related with profitability. Thus it can be said that the conventional banks performed quite well in comparison to the Islamic banks. Reference list Ali, S., Shafique, A., Razi, A. and Aslam, U., 2012. Determinants of profitability of Islamic banks: A case study of Pakistan. Interdisciplinary Journal of Contemporary Research in Business, 3(11), pp. 86-99. Almarazi, A., 2012. Financial performance analysis of the Jordanian Arab bank by using the Dupont system of financial analysis. International Journal of Economics and Finance, 4(4), 86-94. Bader, M. K. I., Mohamad, S., Ariff, M., and Hasan, T., 2008. 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