Did The Islamic Banking Perform Better During The Financial Crisis? Evidence from the UAE

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1 Iteratioal Coferece o Maagemet, Ecoomics ad Social Scieces (ICMESS'2011) Bagkok Dec., 2011 Did The Islamic Bakig Perform Better Durig The Fiacial Crisis? Evidece from the UAE Hela Miiaoui ad Gasto Gohou Abstract It is broadly kow that the Islamic Bakig System (IBS), the mai part of the Islamic Fiacial System, performs better tha covetioal baks. However, traditioal argumets are used (the busiess model of the IBS) to explai this success. This paper takes a differet stad by examiig the performace (o profitability ad productivity) of the mai Islamic fiacial istrumets after the recet fiacial crisis at two levels. Usig balace sheet data for 37 baks of the Uited Arab Emirates (UAE) ad a compesatig differetial framework, we assess the performace gap the covetioal ad Islamic bakig systems. Ucoditioal ad coditioal performace differeces show that, ulike other Gulf Cooperatio Coucil (GCC) coutries, the covetioal bakig is performig better tha the Islamic oe. However, after the crisis, Islamic baks seem to close the differece for most of these performace idicators. Keywords Fiacial crisis, Islamic baks, OLS, UAE. I I. INTRODUCTION SLAMIC fiacial istitutios (IFIs) have experieced a steady growth durig the last decade thaks to strog ecoomic developmet i their host coutries. The basic priciples of IFIs have protected it from the global fiacial crisis. Eve if the sizes of IFIs are relatively small compared to iteratioal stadards, it has to be oted that the prospects for growth ad expasio i o-muslim coutries are strog. Several papers aalysed the performace of bakig system across coutries. The results from may of the previous studies comparig performace of Islamic ad covetioal baks are usatisfactory for several reasos, i particular the sigificace of the differeces i performace the two types of bakig is ofte ot tested. This paper takes a differet stad by examiig the performace (o profitability, credit ad asset growth, ad exteral ratigs) of the mai Islamic fiacial istrumets durig the recet fiacial crisis at two levels. Usig balace sheet data for 37 baks of the UAE ad a compesatig differetial framework, we assess the performace gap the covetioal ad Islamic bakig systems. Ucoditioal ad coditioal performace differeces show that, ulike other GCC coutries, the covetioal bakig is performig better tha the Islamic oe. However, after the crisis, the Islamic baks Hela. Miiaoui, is with Uiversity of Wollogog i Dubai, Kowledge Village, P.O. Box UAE (phoe: ; helamiiaoui@uowdubai.ac.ae). Gasto. Gohou, is with CESS Istitute, G1P4C6 Caada. ( ggohou@cessistitute.org). seem to close the differece for most of these performace idicators. Our mai objective is to assess the performace idicators covetioal baks (CBs) ad Islamic baks (IBs) i the UAE. I this paper, we will assess this gap usig two methods: the ucoditioal ad the coditioal performace idicator differece the bakig systems. I additio, by focusig o oe coutry, we will remove the bias of ecoomy of scale by doig a study across coutries. The rest of the paper is structured as follows: sectio 2 presets a overview of the Islamic bakig while sectio 3 itroduces the UAE bakig system. The literature review of bakig system compariso is doe i sectio 4. The data ad sample are described i sectio 5 ad sectio 6 aalyses the performace idicators of both systems. Fially, Sectio 7 offers cocludig remarks. II. ISLAMIC BANKING SYSTEM REVIEW A Islamic bak is a fiacial istitutio which idetifies itself with the spirit of Islamic legal code (Shari a), as laid dow by the Holy Qura ad Suah, as regards its objectives, priciples, practices ad operatios. As i Fig. 1, IBs adopt various fiacial istrumets i operatig their busiesses. The other baks are kow as covetioal with a Islamic widowig; that is providig services to Muslims i accordace with Shari'a priciples. Fig. 1 Mai Shari a cotracts applied i Islamic bakig The past two decades have witessed a substatial icrease i the umber of IBs, fiacial istitutios ad Islamic fuds i differet parts of the world. It was to meet this demad ad capture this emergig market that CBs started opeig Islamic widows ad Islamic uits for those cliets who do ot wat to idulge i iterest-based trasactios. This covictio 630

2 Iteratioal Coferece o Maagemet, Ecoomics ad Social Scieces (ICMESS'2011) Bagkok Dec., 2011 created a icreased demad for Islamic products i the field of fiacig, ad gave birth to a market where oly Islamic products are acceptable. Thus, baks workig uder Islamic widows are established to provide a additioal service to Muslim cliets or to offer a variety of products for geeral clietele. There are ow more tha 300 IFIs worldwide icludig baks, mutual fuds, mortgage compaies ad isurace firms. Despite most of IBs are withi emergig ad/or Middle-East coutries, may uiversal baks i developed coutries have bega to valve the massive demad of Islamic fiacial products. Islamic fiacig is at the same time becomig more diverse ad veturesome. Its base has both deepeed ad wideed. IFIs iclude commercial, ivestmet ad offshore baks, isurace compaies ad trust fuds. For the priciples, Islamic bakig has the same purpose as covetioal bakig except that it operates i accordace with the rules of Shari a, kow as Fiqh al-muamalat (Islamic rules o trasactios). The basic priciple of Islamic bakig is the sharig of profit ad loss ad the prohibitio of Riba (iterest or usury). III. THE UAE BANKING SYSTEM The UAE has a remarkably high umber of baks. I fact, i 2010, the umber of fiace compaies licesed to operate i the UAE was 23 ad the umber of licesed ivestmet compaies was 21. Moreover, the umber of locally icorporated commercial baks stood at 23 durig 2010, while the umber of their braches icreased to 732 at the ed of December 2010 although the umber of their electroic/customer service uits remaied at 26. Islamic bakig represets a small compoet (16%) of the UAE bakig sector. All atioal baks are listed either o Abu Dhabi Securities Market (ADSM) or Dubai Fiacial Market (DFM). Accordig to the Iteratioal Moetary Fud report o the UAE, local baks are cotrolled substatially by govermets, rulig families, or Govermet-related etities (GREs), with the exceptio of oe of the 10 largest baks, which is owed by a Dubai merchat family. Baks majorityowed by the public sector cotrol 75 percet of local bakig assets 90 percet whe icludig substatial miority shareholdigs. Data released by the respective GCC cetral baks for 2009 has reaffirmed the UAE bakig system s positio as the largest withi the GCC, with total assets expadig to the USD414 billio [1]. IV. LITERATURE REVIEW Previous literature [2]-[7] has compared the profitability of IBs to CBs usig comparative ratio aalysis. Studies [8]-[14], have examied the performace of IBs usig fiacial ratios. Several other studies [15]-[28] have examied the efficiecy of IBs ad compared with those of CBs ad Islamic widows operatio usig Data Evelopmet Aalysis (DEA) ad/or Stochastic Frotier Aalysis (SFA). Moreover, competitive coditios are likely to affect bak performace ad efficiecy [29], i additio to equity capitalizatio levels [30]. I fact, several authors [31]-[36] have ivestigated the importace of competitive coditios o bak profitability, distiguishig amog Islamic ad covetioal baks ad usig a variety of key idicators (traditioal cocetratio measures, the PR-statistic, the Lerer idex). Differet studies assessed the determiats of profitability of baks. Ideed, accoutig-based studies of bak performace geerally use comprehesive iformatio from fiacial statemets to idetify the determiats of bak profitability, as measured by retur o assets (ROA) or retur o equity (ROE). Some studies [37]-[40] have examied bak-specific factors of profitability (e.g., size, reveue growth, risk, ad cotrol of expeses), while cross-coutries researches [41], [42] have cosidered exteral factors (e.g., iflatio, cocetratio, ad GDP growth) i additio to a few iteral factors of profitability. The results from may of the previous studies comparig performace of IBs ad CBs are usatisfactory for several reasos. First a large proportio of the studies are based o small samples (particularly of IBs). Secod, where sample sizes are large, the data have ofte bee collected across a variety of coutries with very differet ecoomy size. Third, the sigificace of the differeces i performace the two types of bakig is ofte ot tested. Studies have geerally employed few fiacial ratios maily ROE ad ROA to examie the performace of baks. The mai research questios i this paper are twofold: (i) Which bakig system i the UAE perform better before ad after the 2008 fiacial crisis? (ii) What is the level of this performace gap CBs ad IBs i the UAE i terms of profitability ad productivity? The paper cotributes to the literature at two levels. First, it is oe of the first papers that used coditioal ad ucoditioal gap estimatio methods to estimate the differece IBs ad CBs. Moreover, by focusig o oe coutry, the bias of ecoomy of scale is elimiated. V. DATA AND METHODOLOGY The data used i this paper are collected from the balace sheet of each bak i the UAE. The data sources are maily from bak s aual ad iterim reports, Zawya database, ad Zawya Dow Joes for fiacial statemets ad iterim accouts ad the Bakscope database. The data covers 37 mai baks i the UAE, wheever data is available. The balace sheet of each bak allowed us to collect the data to assess the performace of the two systems. The mai purpose of this paper is to assess the magitude of the gap the covetioal ad the Islamic bakig systems usig coditioal ad ucoditioal methodology. To do so, we used two sets of performace idicators to compare the performace of the covetioal ad Islamic bakig systems i the UAE. The first set of performace idicators are six profitability idicators ad the secod set are two productivity variables. 631

3 Iteratioal Coferece o Maagemet, Ecoomics ad Social Scieces (ICMESS'2011) Bagkok Dec., 2011 The profitability idicators measure the ability of the baks to effectively employ their resources. The idicators are the Retur o Average Asset (ROAA); the Retur o Average Equity (ROAE); the Net Icome o Average Asset (NIAA); the Net Icome o Average Asset growth rate (NIAAG); the Net Icome growth rate (NIG) ad the Gross Loa (or credit) Growth (GLG). The productivity idicators measure the efficiecy of the bakig system. We use the Cost to Icome Ratio (CTIR) ad the bak total asset rate (AssetG). The CTIR is useful to measure how costs are chagig compared to icome. It is the ratio of operatig expeses to operatig icome. The followig sectios describe the summary statistics of the two bakig systems i the UAE. The distictio is doe the periods before ad after the fiacial crisis. Table I provides the distributio of market share of IBs ad CBs. I terms of market share, measured by the et iterest profit, the Islamic system icreased its market share from 17% o average 2000 ad 2007 to 20% 2008 ad I terms of omial value, the market share of IBs almost doubled this two periods while CBs market value icreased by about 20%. TABLE I THE MARKET SHARE BY BANKING SYSTEM AND COUNTRY (%) Market share Growth rate of assets IB CB IB CB Fig. 2 provides the evolutio of the aual market share for each of the bakig system. The market share of IBs is costatly improvig from 1995 to A feature to otice is the sharp icrease of IBs just before the crisis (a icrease of 5 poit of percetage 2003 ad 2006). The gai of market share of the IBs cotiued after the to reach 20% i Fig. 2 The market share by bakig system per year The descriptive statistics of profitability ad productivity variables are displayed i Tables II ad III. TABLE II DESCRIPTIVE STATISTICS, (IBS AND CBS) Variable Mea Std, Dev, Mi Max Observatio s ROAA overall 2,5 3,6-25,3 35,1 N = 381 2,2-2,2 9,0 N = 37 withi 3,3-24,9 30,6 T-bar = 10,3 ROAE overall 15,7 31,3-233,1 246,5 N = ,1-14,8 111,0 N = 37 withi 23,2-202,7 151,2 T-bar = 10,3 NIAA overall 3,1 1,7-2,0 18,7 N = 378 1,8-1,3 10,2 N = 36 withi 1,0-4,6 11,7 T-bar = 10,5 NIAAG overall 0,1 1,1-7,6 16,8 N = 340 0,9-0,4 3,8 N = 36 withi 1,0-8,1 16,2 T-bar = 9,4 NIG overall 0,9 8,3-20,8 131,0 N = ,6-3,2 131,0 N = 37 withi 3,9-18,6 45,6 T-bar = 9,2 GLG overall 0,3 1,8-0,8 31,2 N = 332 1,2-0,2 6,1 N = 36 withi 1,6-6,4 25,4 T-bar = 9,2 CTIR overall 43,2 37,9 6,3 402,3 N = ,3 12,2 250,0 N = 36 withi 30,0-100,8 357,0 T-bar = 10,4 AssetG overall 0,2 0,3-0,4 2,6 N = 344 0,4-0,2 2,1 N = 37 withi 0,3-0,8 2,0 T-bar = 9,3 leverage overall 6,9 2,8 1,9 23,0 N = 146 2,5 2,6 13,9 N = 26 withi 1,8 3,4 19,9 T-bar = 5,6 ivcap overall 22,4 13,7 7,2 86,0 N = ,6 9,7 68,2 N = 24 withi 4,7 7,3 49,5 T-bar = 8,6 EquLoa overall 62,8 107,8-4,3 866,7 N = ,7 13,7 540,0 N = 36 withi 46,2-227,0 389,5 T-bar = 9,9 EquAss overall 22,7 16,6-3,2 100,0 N = ,7 2,9 65,3 N = 37 withi 7,9-6,7 79,5 T-bar = 10,3 CusDep overall 86,5 17,6 0,0 100,0 N = ,4 4,3 100,0 N = 32 withi 6,8 59,8 114,7 T-bar = 10,6 BakDep overall 22,1 30,6 0,0 100,0 N = ,9 2,0 100,0 N = 34 withi 6,8-14,7 48,8 T-bar = 9,7 CAR overall 21,5 9,3 10,8 81,6 N = ,4 12,8 62,4 N = 27 withi 5,7 2,3 40,8 T-bar = 7,1 CB overall 0,7 0,4 0,0 1,0 N = 592 0,5 0,0 1,0 N = 37 withi 0,0 0,7 0,7 T = 16 Bsize overall 0,7 0,5 0,0 1,0 N = 592 0,3 0,0 1,0 N = 37 withi 0,3-0,3 1,6 T = 16 Overall, it seems that IBs i the UAE has bee hit harder by the fiacial crisis. Ideed, the ROAA grew o average by 4.6 percet per year 2000 ad 2007 while it grew by

4 Iteratioal Coferece o Maagemet, Ecoomics ad Social Scieces (ICMESS'2011) Bagkok Dec., 2011 percet over the same period of time. We observe a similar tred for the other performace idicator (ROAE ad GLG). TABLE III EVOLUTION OF PERFORMANCE VARIABLES, ALL BANKING SYSTEMS, (%) ROAEG Asset ROAAG NIAAG NIG GLG CTIRG G All baks Covetioal Bakig Islamic Bakig VI. CONDITIONAL AND UNCONDITIONAL GAP BETWEEN BANKING SYSTEMS This sectio presets the performace gap IBs ad CBs before ad after the fiacial crisis usig compesatig differetial framework. We assess, first, the ucoditioal performace gap Islamic ad covetioal bakig systems. The ucoditioal performace gap is calculated as the differece of performace idicators the two bakig systems. A t-test is performed to assess the validity of the test at the statistical level. The results are preseted i Table IV. Based o the six profitability idicators, we caot cofirm the fidigs of previous studies that CBs did perform better tha IBs i the UAE before ad after the crisis. However, this gap is positive but statistically ot sigificat for the ROAE ad the NIAA. Whe we cosider all the period , CBs seem performig better that IBs i the UAE sice the gap is positive ad statistically sigificat. Regardig the operatig cost, the ucoditioal productivity differece shows that IBs have the higher cost to icome ratio but higher growth of its asset. These results are cofirmed overtime. The gaps estimated i Table IV have a importat bias i the sese that they do ot take ito cosideratio the heterogeeous characteristics of the baks i terms of portfolio, loas, exposure, risk takig, etc. To resolve this bias, we estimated the coditioal differece i profitability ad productivity idicators. TABLE IV PERFORMANCE ANALYSIS, UNCONDITIONAL CBS-IBS DIFFERENCE Profitability idicators ROAA CB IB CB-IB * SE ( ) ( ) ( ) ROAE CB IB CB-IB *** *** SE ( ) ( ) ( ) NIAA CB IB CB-IB * SE ( ) ( ) ( ) NIG CB IB CB-IB SE ( ) ( ) GLG CB IB CB-IB *** SE ( ) ( ) ( ) Productivity idicators CTIR CB IB CB-IB *** *** *** SE ( ) ( ) ( ) AssetG CB IB CB-IB *** *** *** SE ( ) ( ) ( ) Note: The statistical sigificace of the two-sample t-test with equal variace o the equality of meas (* sigificat at 10%, ** sigificat at 5%, ad *** sigificat at 1%). Stadard errors of the mea differeces are i paretheses. Sample weights are applied. This coditioal performace differece ca be obtaied by doig a regressio of the idicator o a dummy variable represetig the covetioal bak ad a set of variables represetig the mai characteristics of the baks. I so doig, the coditioal differece cotrols for observable characteristics of baks. The coefficiet of the dummy variable represets the coditioal performace differece IB ad CB systems. Based o the literature, we estimate the followig equatio (1) by period usig Ordiary Less Square (OLS) method: S i =CB i α +X i β + ε i (1) where S i is the value of a performace idicator, CB i is a dummy variable for beig a covetioal bak or ot, X i is the set of idividual bak characteristics (leverage, asset to capital ratio, capital to asset ratio, equity loa to total gross loa, etc.) ad ε i is the error term. The equatio is estimated for three periods: the period , (before the crisis), (after the crisis) ad the whole period For each period the data are pooled to obtai a cross- sectio data set. The coditioal differece i performace for each bakig system was coducted for each variable. Table V reports the estimated performace gap IB ad CB systems for various model specificatios. Various models are specified ad estimated usig OLS. I model 1-3, we estimated the coditioal differece usig the oly the dummy variable CB, ad the size of the bak. I model 4-9, various models are estimated usig bak characteristics. The coditioal differece of bak performace remais large ad i favor of 633

5 Iteratioal Coferece o Maagemet, Ecoomics ad Social Scieces (ICMESS'2011) Bagkok Dec., 2011 the covetioal bakig. The coditioal performace differece is lower tha IBs. For istace i Table V, model 7-9 show that the coditioal differece the covetioal ad Islamic bakig for ROAA are 0.807; ad respectively i the period ; ad The figures for the same period for the ucoditioal differece were 0.41; 1.06 ad 0.85 (see Table IV). The magitude of the differece varies 10% ad 50%. The coditioal differece also shows a iterestig story. The performace gap IBs ad CBs is shrikig after the crisis for all the performace idicators. Model 7-9 for idicator ROAA, NIAA, ROAE, GLG, CTIR ad AssetG are decreasig from the period to the period Hece, eve if i geeral, the performace of IBs is lower tha CBs, this differece is reducig sice the crisis. A followig paper will assess the followig reasos of these various performaces of the bakig system. VII. CONCLUSION This paper is a first attempts to measure the value of the performace differece of bakig systems. I this paper, we aalyzed the profitability usig ucoditioal ad coditioal differetiatio ecoometric regressio. Usig balace sheet data for 37 baks of the UAE ad a compesatig differetial framework, we assess the performace gap the covetioal ad Islamic bakig systems. Ucoditioal ad coditioal performace differeces show that, ulike other GCC coutries, the covetioal bakig i the UAE is performig better tha the Islamic oe. However, after the crisis, IBs seem to close the differece for most of these performace idicators. As for the future research directio, it will be very iterestig to provide a uderstadig ad explaatio of the performace gap that exists IBs ad CBs. TABLE V CONDITIONAL GAP BETWEEN CBS AND IBS IN THE UAE Pael 1 Pael 2 Pael 3 (1) (2) (3) (4) (5) (6) (7) (8) (9) ROAA * 0.887* (0.539) (1.079) (0.491) (0.763) (0.244) (0.438) (0.768) (0.247) (0.458) ROAE 16.99*** 16.70** 16.63*** ** (4.900) (8.315) (4.144) (3.989) (2.166) (2.406) (4.142) (2.193) (2.558) NIAA 0.462* * (0.274) (0.410) (0.228) (0.335) (0.192) (0.157) (0.270) (0.218) (0.142) NIG * * (0.566) (4.076) (1.230) (0.425) (0.915) (0.516) (0.412) (1.256) (0.561) GLG ** *** (0.373) (0.149) (0.263) (0.180) (0.0876) (0.0770) (0.181) (0.0946) (0.0839) CTIR *** *** *** ** *** *** ** *** *** (5.808) (11.06) (5.136) (5.488) (2.984) (2.647) (5.740) (3.219) (2.811) AssetG *** *** *** ** (0.0539) (0.0820) (0.0453) (0.175) (0.0567) (0.0700) (0.162) (0.0670) (0.0757) Notes: The above table reports the estimated performace gap IB o CB systems. The gap reported is the coefficiet of the dummy variable CB obtaied from the followig regressio: (Performace idicator) t = CB t β + X t γ +ε, where Performace idicator is the profitability or productivity idicator for each bak (the depedet variable), CB t is a dummy variable for beig a covetioal bak (CB) or ot (Islamic bakig system is the compariso oe), X t set of bak related characteristics variables; εi is the error term. Three pael of regessio are defied depedig of the vector (X t ). Pael 1 uses oly the size of the Bak as the X t vector. A bak is defied as large if its asset value is great tha the media asset values of all baks. Pael 2 uses the leverage, the ivestmet-capital ratio, the equity-asset ratio, the CAR ad the bak size as depedet variables (X t ). Fially, i additio to the depedet variable of pael 2, pael 3 used equity-loa ratio, the baks deposit ratio ad the customer deposit ratio as (X t ). Robust stadard errors are i paretheses; * sigificat at 10%; ** sigificat at 5%; *** sigificat at 1%. 634

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