Determinants of Islamic bank profitability in the MENA region

Transcription

1 Int. J. Monetary Economics and Finance, Vol. 2, Nos. 3/4, Determinants of Islamic bank profitability in the MENA region Karim Ben Khediri* CEROS, University Paris Ouest Nanterre La Défense, 200 Avenue de la République, Nanterre Cedex, France and FSEG Nabeul Merazga, Route Hammamet 8000 Nabeul, Tunisia *Corresponding author Hichem Ben-Khedhiri CEROS, University Paris Ouest Nanterre La Défense, 200 Avenue de la République, Nanterre Cedex, France Abstract: This paper examines the determinants of Islamic bank profitability in the MENA region, during the years We estimate several specifications to study the impact of bank-specific and country-specific variables, including macro-economic conditions, market structure and institutional development, on bank profitability. The results provide evidence suggesting that capitalisation and management efficiency enhance bank profitability. The results also indicate that bank profitability is positively associated with, economic growth, inflation and bank concentration. We also show that Islamic bank profitability is higher in countries with better socio-economic conditions and better legal systems. Keywords: bank; Islamic; MENA; performance; profitability. Reference to this paper should be made as follows: Ben Khediri, K. and Ben-Khedhiri, H. (2009) Determinants of Islamic bank profitability in the MENA region, Int. J. Monetary Economics and Finance, Vol. 2, Nos. 3/4, pp Biographical notes: Karim Ben Khediri is an Associate Researcher at the CEROS, University Paris Ouest Nanterre La Défense, and Assistant Professor of Finance at the University of Economic Science and Management of Nabeul. He received his PhD in Finance from the Institute of Business Administration of Caen, France. His main interests include corporate governance, derivatives, risk management and banking. Copyright 2009 Inderscience Enterprises Ltd.

2 410 K.B. Khediri and H. Ben-Khedhiri Hichem Ben-Khedhiri is pursuing his PhD at the University Paris Ouest Nanterre La Défense, France. He received his MSc International Banking and Financial Services from the University of Reading, UK. His main fields of interest are banking and carbon finance. 1 Introduction The financial world has set conventional banking as a standard practice that is driven mainly by the profit maximisation principle. However, Islamic banking principles have been attracting increased attention from academic researchers and regulators, both in developing and developed countries, as a result of their distinguished micro-operating fundamentals. The prohibition of interest payments by Islamic Shari ah 1 (Islamic law) has made the equity and profit sharing the cornerstone of its operational structure activities. This ban on interest does not mean that capital is costless in an Islamic system. In fact, it recognises funds as a factor of production but it does not allow the fund-providers to make a prior or pre-determined claim on the form of interest. This risk sharing principle provides theoretically better long-term allocation of funds to investments with higher risk-return profiles and, subsequently, greater economic growth (Mills and Presley, 1999). In this framework, two main types of partnerships between the bank and the borrower can be identified. The first, called Mudarabah financing (profit-sharing), is one in which the bank provides the entrepreneur with funds for a specified period of time for a predetermined share in the profits made with the use of those funds. If there are financial losses, these are borne entirely by the bank and the entrepreneur loses only the value of time and effort. The second type, called Musharakah financing (joint venture), is one in which there are many contributors of funds with each sharing profits and losses in proportion to their capital contributions. Moreover, the profits of Islamic banks arise from one of these three modes of financing: i equity and profit sharing ii credit purchase iii leasing. At the foundation of Shari ah compliance there are two concepts of profitability: Profit and Loss Sharing (PLS) and mark-up. Islamic banking is based on interest-free as no transaction must involve the collection and the payment of interest of any kind. On the profit and loss sharing side the rate of return on the financial assets is either not known or is fixed before the undertaking; in the case of mark-up the purchase-resale transaction is determined with reference to the benchmark rate of return. Research about these two principles show that the benefits inherent in the PLS are higher than those of mark-up but over a very short period and that the mark-up principle which dominates the operations of Islamic banks may be regarded as a form of debt financing (Bellalah, 2003). Poor investment decisions by the bank have a direct impact on the returns given to depositors, as the rate of return is determined by the profit-and-loss sharing ratio, whereas in conventional banking the borrower of the money become responsible for the entire risk.

3 Determinants of Islamic bank profitability in the MENA region 411 Islamic banks do not share their profits with depositors, because profit is defined as the final amount of wealth attributable to shareholders in a period of time. What is shared between shareholders and depositors is a variable one which can be defined as the bank s Income Before Cost Funding (IBCF), equities being excluded here from the scope of funding. The cost of non-equity funds is precisely what distinguishes Islamic banks from conventional banks. While conventional banks rely on debt and deposits with mainly fixed interest rates, Islamic banks rely on a funding base whose cost depends on the return of its assets (Hassoune, 2002). Conventional banks use both debt and equity to finance their investments, while Islamic banks depend mainly on equity financing and customers deposit accounts, i.e., current, saving, and investment. The cost of capital in conventional banks represents the cost of debt and equity, whereas the cost of capital in Islamic banks represents the profit and loss shared by depositors and equity holders in Islamic banks. Khan (1996) compares the balance sheet characteristics of Islamic banks with conventional banks. He finds that the balance sheet of Islamic banks has no fixed liabilities, and deposits are considered as shares. Therefore, any shock on the asset s side would be absorbed and adjusted on the liability side. This would create more stability in Islamic banks. By contrast, in conventional banks, when a crisis occurs on the asset s side, banks turn to liability management and this would lead to instability. Subsequently, bankruptcy is less likely to happen in Islamic banks, because operations are based on solvency and trustee of partners. Islamic banks rely on the principle of Shari ah compliance to promote the fair distribution of wealth between the agents. Aron (2000) argues that institutions affect growth because they influence the costs of transactions and the efficiency of production. Consequently, the institutional environment may well affect the way in which banks conduct business, and their rate of efficiency. Demirgüç-Kunt and Huizinga (1999) document that institutional environment can affect commercial interest margins and profits. Nonetheless, most empirical studies on the profitability of banks ignored the influence of the degree of development of institutional factors such as, the quality of the judicial system, corruption, and socio-economic development. This study will show that indicators which were overlooked over the past have a significant impact on the profitability of Islamic banks in the MENA. The aim of this paper is to uncover the key institutional, structural and bank-specific elements that may influence the rate of profitability of Islamic banks in the selected MENA countries (Bahrain, Egypt, Iran, Jordan, Kuwait, Qatar, Saudi Arabia, Tunisia, UAE, and Yemen). The outcome of this research will contribute both to the international debate on the dynamics of banking system and to the understanding of the micro-islamic banks profitability. The study will take into account the country-specific environment in addition to the banks explicit internal-characteristics. The remainder of the paper is organised as follows. Section 2 reviews the existing empirical literature on bank performance. Section 3 presents the variables. Section 4 describes the data. Section 5 presents and discusses the empirical results. Finally, Section 6 concludes the study. 2 Literature review A recent strand of the literature has turned to the analysis of the performance differences and the assets/liability structure between conventional and Islamic banks

4 412 K.B. Khediri and H. Ben-Khedhiri (Rosly and Abu Bakar, 2003; Hassan and Bashir, 2003; Shubber and Alzafiri, 2008; Srairi, 2009). These researches were mainly based on the empirical studies on the profitability of conventional banks profitability which they have focused on a specific country (Angbazo, 1997; Ben-Khedhiri et al., 2008) and multi-country setting (Demirgüç-Kunt and Huizinga, 1999; Pasiouras and Kosmidou, 2007; Ben Naceur et al., 2008). Shubber and Alzafiri (2008) report that deposit accounts of Islamic banks cannot be considered as a liability because they fall within the definition of profit-and-loss sharing principles. They find a high-positive correlation coefficient between Islamic bank s market value and the size of its deposits. In addition, they show that the market value of Islamic banks is independent of the cost of its capital. Similarly, Karim and Ali (1989) investigate the effect of the interaction between the market competition and financial strategies adopted by two Islamic banks over the period They report higher profitability for Islamic banks and stated that Islamic banks rely more upon depositors in financing their investment during favourable economic conditions, rather than on equity capital. Chong and Liu (2009) argue that Islamic banking, as it is practiced today in Malaysia, tends to deviate substantially from the PLS paradigm. Using the Engle-Granger error-correction model, the authors show that changes in conventional deposit rates cause changes in Islamic investment rates, but not vice versa and that the Islamic investment rates are positively related to conventional deposit rates in the long-term. In addition, they report that when the Islamic investment rates deviate far above (below) the conventional deposit rates, the rates will adjust downwards (or upwards) towards the long-term equilibrium level. Subsequently, the researchers concluded that the Islamic banking deposit PLS practices are in reality closely pegged to the deposit rate setting practices of conventional banking and that the Islamic deposits are not really interest-free, but are very similar to conventional-banking deposits. A well cited paper by Demirgüç-Kunt and Huizinga (1999) analyse data for 80 countries during the years to investigate a variety of determinants: bank-specific variables, such as the default risk and bank size, macroeconomic variables (inflation and output growth), regulatory components (explicit and implicit bank taxation), financial structure, legal system such contract enforcement and institutional indicators, in addition to deposit insurance regulation on bank interest margins and profitability. They document that high ratio of equity to assets, high ratio of loans to total assets, greater bank size, overhead costs, high foreign ownership and high inflation lead to increase in the bank interest margins. Nonetheless, the study documents a statistically negative relationship between implicit tax and the bank mark-up and the insignificant influence of annual rate of growth. Furthermore, the study shows that legal and institutional differences such as contract enforcement, efficiency in the legal system, and lack of corruption are associated with lower interest margins and lower profitability. Kalluru and Bhat (2008) examine the determinants of profitability of commercial banks in India. Using a panel data of 87 commercial banks for the period , they report that the profitability of banks is affected by banks own characteristics, industry structural variables and macroeconomic variables. They document that bank ownership and political parties in power play a crucial role in determining bank profitability in India. Ben-Khedhiri et al. (2008) examine the determinants of bank profitability and differentials in interest margins for Tunisian deposit banks during the period They find that the more profitable banks are those with greater size of operations, better management quality and higher capital ratio.

5 Determinants of Islamic bank profitability in the MENA region 413 Islam (2003) investigates the development and performance of commercial banks in the GCC for the period He uses several financial ratios to measure bank performance and shows that GCC banks perform well relative to western banks. Moreover, Olson and Zoubi (2008) report higher Return On Assets (ROA) for Islamic banks. They find that ROA of Islamic banks were 25% higher than that of conventional banks and that Return Of Equity (ROE) averages 18.2% annually for Islamic banks against 14.4% for conventional banks. Similarly, Rosly and Abu Bakar (2003) point out that profitability was statistically higher for Malaysian Islamic banks during the period than for conventional banks. Operating-efficiency and asset-utilisation ratios were smaller for Islamic banks, suggesting that there may be some financial and operational differences between banks. They report that Islamic banks are more profitable than conventional banks. Bashir (2000) examines the determinants of profitability and rate of return margins of 14 Islamic banks from the Middle East over the years He finds that capital ratio and loans portfolio contributes to the profitability of banks. Moreover, the study reports a positive relationship between banks liquidity, stock market development and macro-economic conditions, as reflected by the GDP per capita and inflation. In a later paper, Hassan and Bashir (2003) use an extended panel data sample from 43 Islamic banks over the period They found that high equity to total assets ratio leads to higher profitability while the size of loan to total assets contributes negatively to banks profitability. Moreover, they report that implicit and explicit taxes affect the bank performance measures negatively while favourable macro-economic conditions impact (GDP growth rate) performance measures positively. In a recent paper, Ben Naceur et al. (2008) use the Data-Envelopment Analysis (DEA) approach to assess bank efficiency in a non-parametric setting of selected MENA banks (Jordan, Egypt, Tunisia and Morocco). They account for the empirical analysis of the effects of institutional environmental and regional financial structure on the profitability of banks. They report a robust association of a number of environmental factors with efficiency measures; mainly, the legal system, banking sector development as measured by credit to provide sector by banks and stock market development. In addition, the study shows a positive relation between banks cost efficiency, banks capitalisation and liquidity in the region. Srairi (2009) examines the effect of a number of bank-specific, economic conditions, and financial structure, on the profitability of Islamic banks in the Gulf Cooperation Council with reference to conventional banks. He finds the proxy of operational efficiency (as measured by the cost to income ratio) to be significantly negative for the two types of banks. A positive association between financial risk and size was found to be significant for both banks. However, the study documents a negative relationship between the liquidity and the profitability for Islamic banks and argues that this may be due to the excess of liquid assets that are generating a cost of opportunity. Moreover, the author reports a significant association between net loans to total assets and profitability to be yet another opposite sign for Islamic (+) and conventional banks ( ). He explains the negative association found within the conventional banks by the accumulation of higher reserves for loan losses which conventional banks have to bear alone. The study also documents a positive link between financial risk (measured by total liabilities/total assets), size and profitability. In addition, the paper reports supporting evidence on the positive impact of economic growth, inflation, stock market development and concentration on the profitability of banks.

6 414 K.B. Khediri and H. Ben-Khedhiri 3 Variables This section introduces our contextual variables, which are grouped into internal, market-specific, macro-economic and institutional determinants. 3.1 Internal banks characteristics The internal bank-specific variables are used extensively in the empirical research. This paper recalls three proxies of bank characteristics; capital adequacy as measured by Equity to Total Assets (EQTA), asset quality as measured by Net Loans to Total Assets (NLTA) and Cost to Income Ratio (CIR). EQTA can be interpreted as the bank capital strength or insolvency risk. Within the PLS paradigm, customers deposit are regarded as equity rather than a liability, as opposed to conventional banks. Any shock on the asset s side would be absorbed and adjusted on the banks liability side. Therefore, a high level of equity would create more stable banking system with lower cost of funding, lower likelihood of bankruptcy and, subsequently, higher profitability. Well-capitalised banks face lower expected bankruptcy costs for themselves and their customers and, therefore, low cost of funding (Berger, 1995). A high capital ratio also indicates the ability to grow through either internal means or acquisitions. Therefore, we expect a positive association between the level of equity and the profitability of Islamic banks. NLTA reflects the lending activities power of banks. Banks with important volume of loans are more exposed to credit risk and, hence, higher profitability. Islamic banks are exposed to default risks on their financing due to the asymmetric information that reign ex-ant. As a result, they have to be expert in allocating customer s deposits to profitable investment projects via the Islamic financing principles that prohibit interest payments. Bad allocation decisions of funds by Islamic banks has a direct impact on the returns given to depositors, as the rate of return is determined by the profit-and-loss sharing ratio. Fund-providers and find-seekers are seen as partners because they have to share profits and bears losses together. A positive relationship between the ratio of net loans to total assets and profits was documented in most studies (Demirgüç-Kunt and Huizinga, 1999). CIR is defined as the ratio between operating expenses and operating revenues. It is one of the main key performance indicators of the bank s efficiency. The lower the cost to income ratio the more efficient and profitable the bank is. Therefore, we expect a negative correlation between CIR and the profitability of banks. 3.2 Macroeconomic conditions Bank profitability is expected to be sensitive to macro-economic conditions. Widely used proxies for the effect of the macro-economic environment on bank performance are real GDP growth and inflation. Lending could decrease during adverse economic conditions, since such periods are normally associated with increased risk and size of non-performing loans in the economy. In this context, provisions held by banks will be higher due to the deterioration of the quality of loans, and capital equity could also follow down. Accordingly, demand for investment and stock market transactions would rise considerably during economic expansion and, subsequently, the banks profit margin is more likely to increase. Income could rise faster than costs, leading to increased profits, while the opposite may happen during economic slowdowns (Demirgüç-Kunt and

7 Determinants of Islamic bank profitability in the MENA region 415 Huizinga, 1999). Therefore, we anticipate a positive relationship between the general economic activities as measured by the real rate of GDP growth and the banks profitability. We also control for macro-economic risk by incorporating inflation in the regression. Revell (1979) argues that the effect of inflation on banks depends on whether banks wages and other operating expenses increase at a faster rate than does inflation. The relationship between the inflation rate and profitability depends on whether or not inflation is anticipated. An inflation rate fully anticipated by the bank s management implies that banks can correctly adjust their revenues faster than their costs and thus acquire higher profits. On the contrary, unanticipated inflation could lead to improper adjustment of revenues and hence to the possibility that costs could increase faster than revenues. Demirgüç-Kunt and Huizinga (1999) note that in developing countries high interest rates are associated with higher interest margins and profitability because demand deposits often pay zero or below market interest rates. Hence, we expect a positive association between inflation and bank performance. 3.3 Environmental variables In this section we introduce our related market structural and institutional variables. We use various indices of the degree of the development of the market structure and institutional environment, such as, stock market development, bank s concentration, corruption, socioeconomic conditions and legal system Market structure The stock market is the basic of economic development as it promotes efficiency via capital accumulation and allocation. Stock market development enables banks and firms to raise long-term capital for financing new projects and for monitoring firms more effectively. At a higher level of stock market development, much information on publicly traded firms is made available, enabling banks to better evaluate credit default risk. Thereby, in countries with well-developed stock markets, banks have greater profit opportunities (Demirgüç-Kunt and Huizinga, 2000). This would reflect the complementarities between banks profitability and stock market development. The study employs the ratio of stock market capitalisation to GDP as a proxy of the degree of capital market development. In this context, some empirical studies show that stock market development has a positive impact on the profitability of commercial banks (Bashir, 2000; Demirgüç-Kunt and Huizinga, 2000). One of the most contested issues in economics is the profitability-concentration nexus, which is conventionally known as Structure-Conduct-Performance (SCP). The foundation of this theory is that certain markets are conducive to monopolistic behaviour. It claims that banks are able to extract monopolistic rents in concentrated markets by their ability to offer lower deposit rates return to charge higher loan rates, as a result of collusion or other forms of non competitive behaviour. The more concentrated the market, the less the degree of competition. Thereby, firms in more concentrated markets will earn higher profits (for collusive or monopolistic reasons) than firms operating in less concentrated ones, irrespective of their efficiency. By contrast, the market efficiency structure hypothesis challenges the SCP hypothesis. It argues that market concentration is the result of the firm s large market share obtained form superior

8 416 K.B. Khediri and H. Ben-Khedhiri managerial skills and economic scale efficiency. Ben Naceur et al. (2008) show that increased concentration contributes to improved cost efficiency in the selected MENA region while Demirgüç-Kunt and Huizinga (1999) report that increased bank concentration improves bank profitability. The study measures concentration as the assets of the three largest banks to the assets of all banks operating in the country Institutional development For a more inclusive understanding of the determinants of bank s performance, we account for several institutional variables. The institutional environment that contributes to economic development may improve the financial structure and, consequently, the functioning of banks (Demirgüç-Kunt and Huizinga, 1999). The observance of law and the upgrading of socio-economic conditions (for example, income distribution, and quality of life) may contribute to the improvement of consumption patterns and business performance. This study tests three institutional indices; Corruption (COR), Law and Order (LOW) and Socio-Economic Conditions (SOC). Demirgüç-Kunt and Huizinga (1999) report that indicators of better contract enforcement, efficiency in the legal system, and lack of corruption are associated with lower realised interest margins and lower profitability. The corruption within the system distorts the economic and financial environment, and reduces the efficiency of government and business by enabling people to take advantage of their positions. The most common form of corruption met directly by business is financial corruption in the form of bribes. Socio-economic conditions assess of the quality of life (access to health and education, lifestyle, fair distribution of income, etc). Improvements of socio-economic conditions lead to rise in the income, consumption and savings patterns of agents, economic growth and, subsequently, firm s performance. We expect a positive relationship between banks profitability and socioeconomic conditions. Law and finance literature was pioneered by La Porta et al. (1998). They show that some environments are more conducive to designing and enforcing financial contracts than others, and that better contracting leads to better outcomes. The Law element is a measure of the strength and impartiality of the legal system, while the Order element is an assessment of popular observance of the law. Berger and Udell (2006) suggest that elements of the legal institutional infrastructure may have important effects on the abilities of banks to use hard information lending technologies to extend credits to firms. A recent study by Qian and Strahan (2007), document that strong creditor rights seem to enhance loan availability as lenders are more willing to provide credit on favourable terms. Moreover, lower levels of contract enforcement may induce banks to require higher interest margins, and investors to require higher profitability to compensate for the additional risk. Therefore, high rating will reflect an inadequate legal system and, therefore, high risk premiums, as banks will require higher costs to recollect their loans in case of defaults and deter borrowers from investing in excessively risky investments and low returns activities. Ben Naceur et al. (2008) document a positive relationship between the quality of the judicial/legal system and banks efficiency.

9 4 Data Determinants of Islamic bank profitability in the MENA region 417 Our sample is an unbalanced panel dataset of 40 Islamic banks operating in the MENA region over the period , and comprising 238 observations. We use annual bank level and macro-economic data from ten countries (Bahrain, Egypt, Iran, Jordan, Kuwait, Qatar, Saudi Arabia, Tunisia, United Arab Emirates, and Yemen). The bank variables are obtained from the BankScope database, maintained by Bureau Van Dijk. The macro-economic variables (including inflation and Real DGP growth) are obtained from the IMF s International Financial Statistics (IFS). The market structure data were drawn from the updated (Beck et al., 1999) which is published by the World Bank. Finally, the institutional development variables are obtained from the International Country Risk Guide (ICRG) produced by the country-risk rating agency Political Risk Services Group. Table 1 provides the definitions and sources of variables. Table 1 Variables, definitions and sources Variables Definitions Sources ROA Net profits before taxes to total assets BankScope EQTA Equity to total assets BankScope NLTA Net loans to total assets BankScope CIR Cost income ratio BankScope INF The annual inflation rate IMF GDPG The real Gross Domestic Product (GDP) growth IMF BC The three largest banks assets to total banking sector assets Work Bank SMC The ratio stock market capitalisation to GDP Work Bank COR The corruption index ICRG LOW The law and order index ICRG SOC The socio-economic conditions index ICRG Table 2 presents summary statistics for the banks profitability by country for the period We find that Islamic banks in Kuwait and Bahrain have the highest profitability ratio with greater standard deviation, while the returns on assets for Islamic banks in Egypt, Jordan and Iran are lower than 1%. Table 2 Bank profitability (%), by country covering the period No. of banks Mean Median S.D. Bahrain Egypt Iran Jordan Kuwait

10 418 K.B. Khediri and H. Ben-Khedhiri Table 2 Bank profitability (%), by country covering the period (continued) No. of banks Mean Median S.D. Qatar Saudi Arabia Tunisia UAE Yemen Table 3 provides descriptive statistics for variables, on average over the period The average ROA for the sample banks is 2.74 %, while the standard deviation is 4.3%, which is almost 2 times the mean. The mean (median) value of the equity to total assets ratio is 24.93% (12.55). The mean (median) value of the net loans to total assets is 54.31% (55.48). The average (median) value of the cost income ratio is 54.41% (49.79%). The average ratio of GDP growth in MENA is 5.87% while inflation is 5.29% on average. The bank concentration in the MENA region is 73% on average. Finally, the average value of the ratio of stock market capitalisation to GDP is 0.7. Table 3 Descriptive statistics for Islamic banks in the MENA region, on average over the period Mean 25th percentile Median 75th percentile Standard deviation ROA EQTA NLTA CIR GDPG INF BC SMC The correlation coefficients matrix is reported in Table 4. We find that the ROA is positively and significantly correlated with the equity to total assets ratio, and significantly and negatively correlated with both the ratio of net loans to total assets and the cost to income ratio. We also find that several country characteristics are significantly correlated with the bank profitability. The correlation coefficients on the real GDP growth as well as the stock market capitalisation to GDP are positive and significant at the 1% level. The bank concentration is positively correlated with the ROA, but is not significant. The correlation coefficient on the inflation rate is negative and significant. Table 4 Correlation coefficients matrix ROA EQTA NLTA CIR GDPG INF BC SMC COR LOW SOC ROA 1.00 EQTA 0.50*** 1.00 NLTA 0.24*** 0.28*** 1.00

11 Determinants of Islamic bank profitability in the MENA region 419 Table 4 Correlation coefficients matrix (continued) ROA EQTA NLTA CIR GDPG INF BC SMC COR LOW SOC CIR 0.35*** GDPG 0.19*** ** 1.00 INF 0.19*** 0.45*** * BC * 0.13** 0.11* *** 1.00 SMC 0.35*** 0.29*** 0.15** 0.17** 0.35*** 0.38*** 0.13* 1.00 COR ** 0.20*** 0.14** 0.41*** LOW 0.24*** 0.34*** ** 0.50*** 0.12* 0.33*** SOC 0.27*** 0.30*** *** 0.39*** 0.23*** 0.35*** 0.36 *** 0.43*** 1.00 *Statistically significant at the 10% level. **Statistically significant at the 5% level. ***Statistically significant at the 1% level. The bank profitability is positively and significantly correlated with both the law and order index and the socio-economic conditions index. The correlation between bank profitability and corruption index is negative but not statistically significant. With regard to the correlation between independent variables, the results show that the correlations between inflation and the law and order index are relatively high (0.5). However, none of the remaining variables are correlated to an extent that merits noting. Furthermore, we use the Variance Inflation Factor (VIF) to check whether the independent variables have multi-collinearity problems, and find no serious multi-collinearity problems. 5 Empirical results In order to examine the internal and external factors that affect the profitability of Islamic banks in the MENA region, the following model has been developed: Y ijt = α o + β i X ijt + γ j Z jt + λ t T t + µ j C j + ε ijt (1) where Y ijt is the dependent variable that refers to the ROA for bank i in country j at time t; X ijt are the bank-specific variables for bank i in country j at time t; Z jt are country-specific variables for country j at time t; and T t and C j are time and country dummy variables. Further, α o is a constant, and β i, γ j, λ t and µ j are coefficients, while ε ijt is an error term. The model (1) is estimated using the White (1980) procedure to control the cross-section heteroscedasticity of the variables. Several specifications of equation (1) are estimated, that differ in terms of which bank and country variables are included. The ROA is one of the most widely used profitability ratios because it is related to both profit margin and asset turnover, and shows the rate of return for both creditors and investors of the bank.

12 420 K.B. Khediri and H. Ben-Khedhiri 5.1 The effect of bank-specific and country-specific factors Table 5 presents the regression results when we examine bank-specific characteristics and country-specific factors. Column (1) shows the results for a basic model that specifies the bank profitability only as a function of 3 bank-specific factors plus year-dummies and county-dummies. The model is progressively expanded to include the country s macro-economic variables in columns (2) in place of the country-dummies. Then, the model is further extended to include market structure variables in columns (3). Finally, in columns (4) to (5), the model includes all factors. Table 5 Bank-specific and country-specific factors and bank profitability Intercept (0.055) (0.006) (0.599) (0.726) (0.867) EQTA (0.000) (0.000) (0.000) (0.000) (0.000) NLTA (0.290) (0.108) (0.239) (0.258) (0.238) CIR (0.000) (0.000) (0.000) (0.000) (0.000) GDPG (0.050) (0.148) (0.271) INF (0.050) (0.419) (0.670) BC (0.000) (0.000) (0.002) SMC (0.472) (0.634) Year dummies Yes Yes Yes Yes Yes Country dummies Yes No No No No F Prob > F R² Observations This table provides the empirical results of the effects of bank-specific and country-specific variables on ROA. White s heteroskedasticity consistent standard errors are given in parentheses below the coefficient estimates. Column (1) of Table 4 shows that capital strength and efficiency in expenses management are the main internal factors that affect the profitability of Islamic banks in the MENA region. The ROA is positively and significantly associated with the equity to total assets ratio, indicating that Islamic banks with higher capital ratios are more profitable. This finding is consistent with previous studies (e.g., Demirgüç-Kunt and Huizinga, 1999; Hassen and Bashir, 2003) suggesting that banks with higher equity capital face lower costs of funding because of lower expected financial distress and bankruptcy costs. Also, this result may be explained by the fact that profitable banks remain well capitalised by high retained earnings, resulting in lower need for

13 Determinants of Islamic bank profitability in the MENA region 421 external funding. In other words, well capitalised banks need to borrow less in order to support a given level of assets. We also find that bank profitability is negatively and significantly related to the cost income ratio. This finding supports the results of Srairi (2009). Thus, Islamic banks in the MENA region should take the necessary actions to achieve more efficient cost control in order to improve their profitability. With regard to loan size, the results indicate that the coefficient of the net loans to total assets ratio is not statistically significant. Hence, the level of loans has no impact on the Islamic bank profitability in the MENA region. This result may be explained by the fact that since most of the Islamic banks loans is in the form of profit and loss sharing, the loan-performance relationship depends on the economic growth. When the rate of economic growth is high, the default of PLS loans is lower. Thus, the lower the bank s loans losses provisions are, the higher the bank profit will be. However, when the macro-economic conditions (GDP growth rate) are not favourable, several borrowers are likely to default on their loans (Hassan and Bashir, 2003), resulting in decreased profitability. To check whether the net loans to total assets ratio affects bank profitability differently in countries with different growth levels, we repeat regressions including an interaction variable. The results show that the coefficient of the net loans to total assets ratio variable interacted with GDP growth is not significant. Therefore, we find no evidence that the level of loans of Islamic bank affects the bank profitability in the MENA region. Columns (2) to (5) of Table 4 drop the country dummies variables and instead include country macroeconomic and market structure variables. Column (2) of Table 4 shows that the impact of the indicators of macro-economic conditions on bank profitability is statistically significant. Inflation (INF) is positively associated with ROA. The positive coefficient implies that bank income increases more with inflation than bank costs, resulting in higher profitability. This result may be explained by the fact that fees increase simply because they are correlated to the nominal value of assets under management (Albertazzi and Gambacorta, 2009). Further, the coefficient on real GDP growth is positive and statistically significant, supporting the argument of a positive relation between economic growth and bank profitability. Indeed, an improvement in economic conditions increases lending demand and improve the financial conditions of borrowers. Likewise, a favourable economic condition increases the return on investment from Islamic banking operations such as mark-up (Murabaha), rent-to-own (Ijara), and deferred sale (Bai Mu jal), with positive effects on the profitability. Differences in the market structure are captured by the last two regressors in column (3) of Table 4. The results show that the impact of the market structure on bank profitability is mixed. As expected, we find that the bank concentration has a positive and significant effect on ROA. However, the stock market capitalisation to GDP ratio, reflecting the presence of a large financial market competing with the banking sector, is not statistically significant. Thus a larger stock market capitalisation does not seem to affect the Islamic banks profitability, suggesting that stock market capitalisation neither substitutes for nor complements Islamic bank finance. This result may be explained by the fact that the stock markets in the MENA region are still at the initial stage of development, resulting in a bank-oriented economy instead of a market-oriented economy. In other words, this result reflects how important the banking sector is in the economy in the MENA region in which savers and borrowers meet indirectly with the intermediation of banks.

14 422 K.B. Khediri and H. Ben-Khedhiri Columns (4) and (5) provide results pertaining to the effect of bank characteristics, market structure and macro-economic conditions on bank profitability. The estimated coefficients on the previously specified variables, EQTA, NLTA, CIR, are similar to those in regressions reported in columns (1) (3). The coefficients of the two country macro-economic variables, GDP growth and inflation, remain positive but are no longer statistically significant in both models (4) and (5). Finally, the coefficient of stock market capitalisation is also statistically insignificant. 5.2 The effect of institutional factors Table 6 provides results regarding a set of institutional development variables: COR; LOW; and SOC including to the baseline models in Table 5. Of the three institutional development variables, two are statistically significant. The socio-economic conditions index has a positive and significant impact on the ROA. Thus, Islamic banks in countries with better socio-economic conditions are more profitable. Table 6 Institutional factors and bank profitability Intercept (0.012) (0.062) (0.017) (0.843) (0.213) (0.045) EQTA (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) NLTA (0.137) (0.058) (0.086) (0.241) (0.191) (0.232) CIR (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) GDPG (0.167) (0.236) (0.837) INF (0.372) (0.167) (0.146) BC (0.000) (0.001) (0.000) COR (0.223) (0.370) LOW (0.000) (0.049) SOC (0.082) (0.049) Year dummies Yes Yes Yes Yes Yes Yes F Prob > F R² Observations This table provides the empirical results of the effects of institutional variables on ROA. White s heteroskedasticity consistent standard errors are given in parentheses below the coefficient estimates.

15 Determinants of Islamic bank profitability in the MENA region 423 The law and order index reflects the quality of the legal system and the enforcement of legal contracts. The scale of the index ranges from 0 to 6, with higher scores for better quality and enforcement of the legal system. We find that a higher value of the law and order index is significantly associated with a higher ROA. Thus, bank profitability tends to be higher in countries with better judicial and legal systems, and better socio-economic conditions. That is, governments have to improve their socio-economic conditions, as well as legal systems, in order to enhance banks profitability and, consequently, the financial intermediation role played by banks in the MENA region where a larger percentage of firms and individuals tend to depend on banks to meet their external funding needs. For the last institutional variable, we find that the estimated coefficient of the corruption index is statistically insignificant. Therefore, Islamic banks profitability does not seem to be linked to the level of corruption. We also find that the estimated coefficients of the earlier bank characteristics variables, EQTA, NLRA, CIR, are qualitatively similar to those in the regressions reported in Table 5. Columns (4) (6) of Table 6 show that controlling for macro-economic conditions and market structure does not alter our results in terms of either the institutional development variables or the bank-specific variables. In respect to country-specific variables, the bank concentration affects, significantly and positively, bank profitability. However, GDP growth and inflation are insignificant. 5.3 Robustness check In this section, we check the statistical robustness of the regressions, particularly the effect of the outliers. First, in order to minimise the effects of measurement errors, we have excluded all the outliers by deleting the extreme bank/year observations (5% lowest values and 5% highest values) for ROA variable. As shown in columns (1) (3) of Table 7, excluding these outliers from our tests does not change our main results. Table 7 Institutional factors and bank profitability Intercept (0.006) (0.054) (0.571) (0.884) (0.071) (0.005) EQTA (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) NLTA (0.446) (0.253) (0.300) (0.331) (0.222) (0.292) CIR (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) GDPG (0.108) (0.212) (0.901) (0.142) (0.225) (0.861) INF (0.765) (0.164) (0.153) (0.615) (0.600) (0.398) BC (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

16 424 K.B. Khediri and H. Ben-Khedhiri Table 7 Institutional factors and bank profitability (continued) COR (0.699) (0.240) LOW (0.302) (0.024) SOC (0.319) (0.002) Year dummies Yes Yes Yes Yes Yes Yes F Prob > F R² Observations This table provides the empirical results of the effects of institutional variables on ROA. White s heteroskedasticity consistent standard errors are given in parentheses below the coefficient estimates. Columns (1) to (3) provide results without the outliers. Columns (4) to (6) provide results when we apply the winsorisation approach. Second, we have applied winsorisation to the extreme two 5% of the distribution of ROA by replacing every outlier lower than the 5th percentile with the value of the 5th percentile and every outlier upper than 95th percentile with the value of the 95th percentile for the ROA. Again, as shown in columns (4) (6) of Table 7, this approach does not alter our findings, indicating that our results are robust. 6 Conclusions This paper extended earlier empirical studies on the determinants of bank profitability in several important dimensions. We analyse the relationship between internal and external factors and Islamic banks profitability. More specifically, we examine the effect of bank characteristics, macroeconomic conditions, market structure and the quality of institutional development on bank profitability. Using a sample of 40 Islamic banks from ten countries in the MENA region over the period , we confirm some findings from earlier research; for instance, a positive relationship between capitalisation and profitability, and a negative relationship between cost-income ratio and profitability. We also find that an increased bank concentration leads to higher bank profitability. Likewise, we show that bank profitability is positively and significantly associated with both GDP growth and inflation, but these results are no longer significant when we include market structure variables in regressions. However, we fail to find a statistically significant effect for the stock market capitalisation. As the first research to link Islamic bank profitability with institutional variables, we make an important contribution to the literature on bank performance. Indeed, we provide, for the first time, evidence indicating that institutional variables are important in explaining variation in Islamic bank profitability. We show that bank profitability is higher in countries with better socio-economic conditions and better legal systems.

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