Islamic Banking Structure and Performance

A cross- country study

Master's Thesis, 2010

58 Pages, Grade: Merit


Table of Contents




List of Tables & Figures

List of Abbreviations

Glossary of Arabic Terms

Chapter 1- Preface
1.1 Background
1.2 Aims and Research Questions
1.3 Data and Methodology
1.4 Dissertation Structure

Chapter 2- Islamic Banking Framework
2.1 Introduction
2.2 Islamic Banking Overview.
2.3 Islamic Banking Model
2.4 Main features of top performing Islamic banks
2.5 Conclusion

Chapter 3- Literature Review
3.1 Introduction
3.2 Problem of the Study
3.3 SCP Paradigm: the theoretical part of the study
3.4 Past Studies and Findings
3.4.1 Conventional Banking Literature in EU
3.4.2 Islamic Banking Literature
3.5 Conclusion

Chapter 4- Data and Methodology
4.1 Introduction
4.2 Dataset and Methodology
4.2.1 Data
4.2.2 Methodology
4.3 Model Specification and Description of variables
4.4 Conclusions

Chapter 5- Discussion of Findings
5.1 Introduction
5.2 Initial Investigation: Financial Ratio Analysis
5.3 Primary Investigation; Empirical Analysis
5.4 Discussion of Empirical Findings
5.4.1 Regression results for GCC countries
5.4.2 Regression results for non- GCC countries
5.4.3 Regression results for Islamized countries 40
5.5 Conclusion

Chapter 6- Conclusion
6.1 Overview
6.2 Limitations and Future Research



I would like to dedicate this dissertation to my parents Sheikh Bassam and Sheikha Marina Awad. Without their support and understanding; I would not be who I am today.

Furthermore, I would also like to dedicate this to all my mentors, professors and most specially my supervisor, who gave me a very special gift- the gift of knowledge and the patience in harnessing my abilities.


This work will not be completed without the help of my supportive family, colleagues and mentors. First of all; I would like to give my utmost gratitude to my supervisor, Dr. Claudia Girardone, for the amount of guidance and support that she gave me in every step that I took. She made this whole experience an enjoyable one, and I would do it all over again with her as my mentor. I am truly honoured to be one of your students!

Also, I would like to thank my professors: Dr. Carlo Rosa and Dr John Nankervis, for sharing their valuable time and knowledge in Eviews, which helped me in running my regressions. Furthermore, Ms. Samah Issah for giving me access to Bankscope database to collect the necessary information that I need. My humblest gratitude to all of you.

Moreover, I would like to thank my parents for their constant encouragement during rough times throughout the year, and for their dedication to my skills, when I am in doubt. I truly appreciate the sacrifices that you both have done for me, and I will continue in pursuing my goals with both of you by my side.

All I have is this page in return to all you have done for the success of my dissertation.


The dissertation explores the variables in relationship with returns in Islamic Banking. It also introduces the history and governance structure of Islamic Banks in the countries within the study. The analysis is based on 49 banks across countries of varying economic stance from the years 2004 to 2008. Important evidence was found showing significant relationship between market concentration and returns in Islamic banks in most of the countries being studied. These findings are consistent with our expectations. Overall, our results suggest that there are highly significant relationships between returns, capital ratios, market concentration and money supply, which can all be used in assessing performance.

Keyword: Islamic Banks, performance, structure, concentration

List of Tables and Figures

Figure 2.1: Governance Structure of Islamic Banks

Table 2.1: Top 20 leading Islamic banks across the sample size (2008)

Table 4.1: Categories of countries studied

Equation 4.1: Simple version of SCP model

Equation 4.2: Regression formula used in the dissertation

Chart 5.1: Trend Analysis for GCC countries

Chart 5.2: Trend Analysis for non-GCC countries

Chart 5.3: Trend Analysis for Purely Islamized Banking Sector

Table 4.2: Definition of variables

Table 5.1: Financial Ratio Analysis across country

Table 5.2: Regression result for GCC countries

Table 5.3: Regression result for non-GCC

Table 5.4: Regression result for Islamized countries

List of Abbreviations

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Glossary of Arabic Terms

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Chapter 1 Preface

‘’Allah has permitted trade And forbidden interest’’

(Quran, 2:275)

1.1 Background

Commercial banking was introduced in Muslim countries in the late 19th century, when trading was at its peak and dealing with banks became unavoidable. For this reason, commoners become aware that a need for a specialized bank was necessary to keep away from dealing in interest which is prohibited in Islam. Soon enough, the idea turned into reality and countries began adopting the virtue (Gafoor, 1995).

An emergence of an institution as such would always have a need on developing performance measures tailored for given circumstances. Islamic law rejects the concept of usury and only operate on a profit sharing basis determined by the central banks. Therefore, depositors are not guaranteed a return on their deposits. Thus, from a depositors view, an Islamic bank is like a mutual fund, that cannot charge interest on their lending (Khan & Mirakhor, 1989).

The main difference between Islamic and conventional banks is that the former does not provide fixed interest in loans and deposits unlike the latter. The returns from Islamic bank activities are distributed through profit sharing, meaning that each client is considered a shareholder in the bank. The profit sharing agreement is regulated by the central bank of each country (Heffernan, 1998). Differences in conventional and Islamic banks are discussed in further chapters.

Islamic banks, due to its innovation, are still on the process of trying various measures in shaping determinants of returns. As such, conventional methods are applied as benchmark for further development. Investigating the determinants of profitability has been a popular topic among researchers. During the past, various factors have been examined and identified to have significant relationship with returns. However, most of these studies have been conducted on conventional banks and only limited studies were carried out on Islamic banks. This study examines the relationship between several variables and Islamic bank returns.

The existing literature on the determinants of profitability of Islamic banks posits

contrasting conclusions and predictions. This shows that a general equation does not exist in answering a broad area as such.

By studying the structure and determinants of Islamic banking performance, this paper contributes to the ongoing literature in several ways. Firstly, the paper provides a simplistic outlook using traditional performance measures while taking prohibition of riba into consideration. Secondly, it uses regression analysis based on the Structure-Conduct- Performance paradigm to determine underlying determinants of Islamic banking returns. Third, the paper seeks to understand the relationship between the internal determinants and returns, while accounting for macroeconomic factors. Finally, the sample contains both full and semi-Islamized banking sector in order to understand if there would be differences in results.

1.2 Aims and Research Questions

A better understanding of widespread phenomena in banking sector, as is Islamic banking, requires specific knowledge of determinants of Islamic banks’ returns. This point is particularly important in performance evaluation of Islamic banks globally. The globalization factor put Islamic banks to not only compete with themselves but with conventional banks in developed financial markets. Furthermore, it is of vast importance to study Islamic banks’ performance in both fully Islamized banking system and mixed systems.

The aim of this dissertation is to apply performance evaluation measures commonly used in conventional banks, into Islamic banks. It seeks to present the determinants of Islamic banks across continents including those with fully Islamized banking sectors. In answering these questions, the dissertation sheds light on the following areas:

Will there be a difference in what determines the returns of Islamic banking if the Islamic banking sector is fully Islamized or mixed?

Can we apply the SCP hypothesis (Berger, 1995) and still get a conclusive result even if the institutions used are Islamic banks?

The dissertation also demonstrates the need for further evaluation regarding performance measures specifically used for Islamic banks. One important factor inhibiting Islamic banking growth is the lack of standardized measurements of returns. This restrained the emergence of Islamic banks on the global markets, since they are unable to show their financial position. For this reason, it is important to investigate tools used for measuring performance in conventional banking, with an attempt to modify according to the unique qualities of Islamic banks. It is of utmost importance for Islamic banks, like conventional banks, to measure their performance in order to function efficiently. For instance, managers would need such information in order to make decisions and evaluate how previous ones affected the banks’ performance.

1.3 Data and Methodology Framework

In this paper, we will use the financial data for a sample of 49 banks for the period 2004-2008 across 11 countries1, obtained through Bankscope database. Macroeconomic data will be used to account for specific economic growth of each country to ease comparability purposes; this data was taken from combined use of Datastream and IMF database. The data will be analyzed using a simple performance ratio evaluation. This technique provides a simple and direct way in evaluating top performers within the sample. Afterwards, regression analysis will employ a straightforward equation. The model considers internal and external variables in order to determine which factors are most likely to determine returns.

The relevant data will then be run in an econometric package called EViews using the OLS method; which is ideal for panel data of this sort. The regression analysis will be the focal point of the research.

1.4 Dissertation Structure

The rest of the study is organized as follows. Chapter 2 (Islamic banking framework) summarizes a brief history of Islamic banks and its structure within the countries being studied. Chapter 3 (Literature Review) outlines explanations and assumptions applied for the research hypothesis. It also indicates results achieved from past studies on both Islamic and traditional Banking. Chapter 3(Data and Methodology) introduces the sample and variables used in the methodology and the model considered throughout. Chapter 5 presents and discusses the empirical results and its implications. Chapter 6 deals with the limitations and future perspectives of the study and summarizes the concluding remarks of the study.

Chapter 2 Islamic Banking Framework

2.1 Introduction

Every economy seeks to transfer funds from savers to investors. Such function can be performed through financial intermediation of market which banks have a major part of. Banks gains interest in exchange to matching different preferences of savers and investors. This facilitates efficient transfer of funds in the economy, however, interest, which is a major part in banking, is prohibited in Islam. Therefore, Islamic countries have to find alternative ways to perform its banking needs.

An Islamic bank, like a conventional bank, utilizes the use of funds from savers to entrepreneurs. It provides banking activities currently known excluding borrowing and lending, on basis of interest. The main difference is conventional banks do such functions in exchange for a predetermined return while Islamic banks perform in accordance to Sharia (Molyneux & Munawar, 2005; Algaoud & Lewis, 2001).

Islamic banks operate in over sixty countries, mostly in the Middle East and Asia. Most of these countries operate a dual system with Islamic banking alongside conventional. Three countries; Sudan, Pakistan and Iran had their entire banking system converted to an Islamic one; while others currently operate in a mixed system (Zaher & Hassan, 2001; Heffernan, 2005; Zaman & Movassaghi, 2001).

2.2 Islamic Banking Overview

Islamic countries within the Gulf made a dramatic decision to enter the financial markets during mid-1970s. Due to the ballooning amount of petrodollars, these countries had their first formal dealing with banks. However, it became apparent that norms of conventional banks do not conform to Sharia. The combination of wealth and piety made the Gulf the perfect place to revive Islamic banking. They succeeded in applying Sharia principles into banking making it the geographic centre for Islamic investment banking that it is known for today (Henry & Wilson, 2004)

Islamic banking activity is highly concentrated in the Middle East. The oil-rich Gulf Cooperation Council countries—Bahrain, Kuwait, Saudi Arabia, and the United Arab Emirates (UAE) — were the start of various developments in Islamic banking; which accounts about 80% of the total assets of Islamic banks (Iqbal & Molyneux, 2005) Bahrain, for instance established itself as one of the leading international centre for Islamic banking, given its stage of development. It has been able to attract large banks due to its location at the centre of the Gulf and its advanced infrastructures. It hosts the Auditing organization for Islamic institutions and among one of the first countries to offer courses in Islamic financial studies. It is also considered to be one of the best off-shore models of Islamic banking due to its policies. It allowed a revolutionary way of applying Sharia in auditing, regulating and developing Islamic financial instruments. (Algaoud & Lewis, 2001; Zaher & Hassan, 2001).

The first interest-free institution, Nasser Social Bank, was established in Egypt in 1971. It provided loans for starting business and interest-free loans to less fortunate. This brought about a spread in attention for further developments in Islamic banking in the private sector which was founded in 1975 in the UAE. Kuwait Finance House, on the other hand started operations in 1977 and so did Bahrain Islamic bank. Each Islamic bank has a unique board structure requirement consist of a lawyer, an accountant and an Islamic scholar. The structure was implemented in order to consider every aspect in making decisions.

One of the most important events in Islamic banking was when Pakistan Iran and Sudan transformed into an interest-free banking system (Molyneux & Munawar, 2005; Jackson-Moore, 2009).The main common objective of these countries is so that it could be an instrument towards social and economic development.

Iran was Islamized in 1983, with a three-year transition period. The order was passed by the government which gave banks one year to pursue. Sudan followed the next year and the whole system was Islamized. It had an abrupt change which gave banks a very short notice; although, the complete transition was implanted in 1990. Pakistan had a different experience as they opted for a gradual change which started in 1947 when they became an independent state.

Other non-GCC countries studied in this dissertation includes Malaysia, Jordan and Turkey. Among them, Malaysia is considered highly established due to its government’s full support in providing capital particularly in financing pilgrimage2 for the less fortunate. The first Islamic bank established in Malaysia was in 1983, which gradually progressed to a dual system later on (Hassan & Lewis, 2007). In Turkey, Islamic principles have been applied as well and they are rapidly expanding. As of October 2008, Islamic banks have represented about 5% of Turkish banking system. Due to such phenomena, it is predicted that Islamic banking is expected to double in the next 10 years (Shanmugam & Zahari, 2009).

2.3 Islamic banking model

Governance structure of Islamic banks differs from that of conventional banks. As mentioned earlier, an additional structure, Sharia Board, has no counterpart in conventional banks. It is responsible with insuring clients that the bank complies with Islamic laws and jurisdictions (Hassan & Lewis, 2007). Islamic banks employ Islamic scholars to ensure that daily activities are in accordance with Sharia. Some banks like Jordan Islamic employs only one religious consultant, others like those in Egypt constitute a separate Board (see Figure 2.1) (Algaoud & Lewis, 2001).

Figure 2.1 represents a simple constructed hierarchy within the Islamic bank.

Although each country would have a contrasting jurisdiction, Islamic laws to be implemented by the Sharia Board do not differ.

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Besides capital and equity, Islamic banks have other sources of funds such as deposittransactions and investment deposits. Their other sources of funds consists of savings, current and investment accounts. Transaction deposits are similar to that of deposits from a conventional bank, except that Islamic banks would pay no return for it. Investment deposits, the principal source of funds, resemble a common share in a firm. The bank offering investment deposits would not guarantee the principal amount; also no fixed interest would be given. Depositors are treated as if they are a co-owner in the bank. A pre-agreed proportion of distributed profit should be determined between the depositor and the bank, which cannot be changed during the life of the contract (Khan & Mirakhor, 1990; Zahari & Shanmugam, 2009).

Islamic banks are considered more efficient than traditional banks as they put emphasis on the productivity of the project. Through this, the resources will go to high-return projects even if the credibility of the borrower is lower instead of low-return, credit-worthy clients. Therefore, the model is more efficient in allocating funds. Conversely, conventional banks focus more in collateral and security (Iqbal & Molyneux, 2005).

Islam fully recognizes the value of financial intermediation, so it does not mean that saving will not be rewarded. They improve allocation of funds, while performing banking activities in compliance with Sharia; which ensures justice and fairness among participants. Given these elements, Islamic banks have positive impact on economic growth (Iqbal & Molyneux, 2005).

2.4 Main features of top performing Islamic banks

This section analyzes the top performing Islamic banks within the sample studied. Below is a table presenting financial statement items chosen for the aims of some preliminary comparisons.

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Table 2.1 presents data on financial position of the top 20 Islamic banks in our sample for the year-end 2008. It appears that Islamic banks in Islamized system did not make the cut apart from that of Iran; probably because it is already well established in its industry as the Islamization process emerged there. It is noticeable that all the GCC countries within the sample are included in the top performing banks; since their economies are stronger compared to the rest.

Now, a brief discussion of some of the major Islamic banks is presented earlier: With total assets of USD23, 079 billion as of December 2008, Dubai Islamic bank is the largest Islamic bank in UAE and one of the leading financial institutions worldwide.


1 Kuwait, Bahrain, Saudi Arabia, UAE, Jordan, Egypt, Malaysia, Turkey, Sudan, Pakistan and Iran.

2 Journey to Mecca conducted by a Moslem.

Excerpt out of 58 pages


Islamic Banking Structure and Performance
A cross- country study
University of Essex  (Essex Business School)
Finance and Investment
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ISBN (eBook)
ISBN (Book)
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islamic finance, islamic banking, banking, finance, SCP theory, SCP paradigm, conventional banking, cross country study, governance, conventional structure
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Sarah Bassam Awad (Author), 2010, Islamic Banking Structure and Performance, Munich, GRIN Verlag,


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