Journal of Islamic Accounting and Business ResearchDoes foreign presence foster Islamic banks' performance? Empirical evidence fromMalaysiaFadzlan Sufian

Article information:To cite this document:Fadzlan Sufian, (2010),"Does foreign presence foster Islamic banks' performance? Empirical evidence fromMalaysia", Journal of Islamic Accounting and Business Research, Vol. 1 Iss 2 pp. 128 - 147Permanent link to this document:http://dx.doi.org/10.1108/17590811011086723

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Users who downloaded this article also downloaded:Fadzlan Sufian, (2007),"The efficiency of Islamic banking industry in Malaysia: Foreign vs domestic banks",Humanomics, Vol. 23 Iss 3 pp. 174-192 http://dx.doi.org/10.1108/08288660710779399Saiful Azhar Rosly, Mohd Afandi Abu Bakar, (2003),"Performance of Islamic and mainstreambanks in Malaysia", International Journal of Social Economics, Vol. 30 Iss 12 pp. 1249-1265 http://dx.doi.org/10.1108/03068290310500652Farhana Ismail, M. Shabri Abd. Majid, Rossazana Ab. Rahim, (2013),"Efficiency of Islamic andconventional banks in Malaysia", Journal of Financial Reporting and Accounting, Vol. 11 Iss 1 pp. 92-107http://dx.doi.org/10.1108/JFRA-03-2013-0011

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Does foreign presence fosterIslamic banks’ performance?

Empirical evidence from MalaysiaFadzlan Sufian

Khazanah Nasional Berhad, Kuala Lumpur, Malaysia

Abstract

Purpose – The paper examines the impact of entry of foreign banks on the performance of theMalaysian Islamic banking sector during the period 2001-2007.

Design/methodology/approach – To maintain homogeneity, the empirical analysis is confined totwo fully fledged domestic Islamic banks, three fully fledged foreign Islamic banks, 11 domesticwindow Islamic banks, and four foreign window Islamic banks during the period of 2001-2007.The paper applies the ordinary least square method, where the standard errors are calculated by usingWhite’s transformation to control for cross section heteroscedasticity.

Findings – The empirical findings suggest that overhead cost is negatively related to MalaysianIslamic banks’ profitability. On the other hand, Islamic banks which are better capitalized and have ahigher level of liquidity tend to be more profitable. It is found that the De Novo commercial banks arerelatively less profitable than their incumbent bank peers, which could be attributed to the differentlevels of knowledge of the market between the incumbent and the De Novo Islamic banks.

Research limitations/implications – Future research could include more variables such astaxation and regulation indicators, exchange rates as well as indicators of the quality of the offeredservices. Another possible extension could be the examination of differences in the determinants ofprofitability between small and large or high and low profitability banks. In terms of methodology,a statistical cost accounting and/or frontier optimization technique, such as the non-parametric dataenvelopment analysis, the stochastic frontier analysis, and/or the Malmquist productivity indexapproach, may be adopted to examine changes in efficiency and productivity of the Malaysian Islamicbanking sector.

Originality/value – While extensive literature exists to examine the performance of conventionalbanking sectors over recent years, empirical works on the Islamic banking sector are still in itsinfancy. Furthermore, studies on Islamic bank performance have focused on theoretical issues and theempirical works have relied mainly on the analysis of descriptive statistics rather than rigorousstatistical estimation. The paper therefore attempts to fill the gap in the literature by providing newempirical evidence on the performance of the Islamic banking sector.

Keywords Islam, Banks, Malaysia

Paper type Research paper

1. IntroductionIslamic banks today exist in all parts of the world and are looked upon as a viablealternative system. While it was initially developed to fulfill the needs of Muslims,Islamic banking has now gained universal acceptance. In Malaysia, the first Islamicbank was established in 1983. It was only after ten years that the government allowedother conventional banks to offer Islamic banking services under their existinginfrastructure and branches. The move to create Islamic banking window operationsallowed the country to enjoy Islamic banking services at the lowest cost and within theshortest time frame. Recently, Malaysia has succeeded in implementing a dual banking

The current issue and full text archive of this journal is available at

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Journal of Islamic Accounting andBusiness ResearchVol. 1 No. 2, 2010pp. 128-147q Emerald Group Publishing Limited1759-0817DOI 10.1108/17590811011086723

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system and has emerged as among the first nations to have a full-fledged Islamicbanking system operating side by side with the conventional banking system[1].

The Malaysian Islamic banking sector has gained its significance and since the year2000, the industry has been growing at an average rate of 18.9 percent per annum interms of assets. Figure 1 shows the growth of total assets (TA) of the Malaysian Islamicbanking sector from amere RM1.2 billion in 1996 to RM157.1 billion in 2007, accountingfor 12.8 percent of the banking system’s TA. The market share of Islamic bank depositsand financing stood at 14 percent of the total banking sector’s deposits and financing.With the growth in Islamic banking industry far surpassing the expansion in thebanking system’s asset base, the industry is expected to be able to achieve thegovernment’s aspiration for the Islamic banking assets to make up 20 percent of thebanking system’s TA by the year 2020.

It has been the Malaysian Government’s aspiration to develop the country as thecapital or hub of Islamic banking worldwide. Tomeet the objective, the government hastaken measures, which among others include liberalizing the Malaysian Islamicbanking sector. The strategy is to create more competition, to tap new growthopportunities, and to raise the efficiency of the Malaysian Islamic banking industry as awhole. The Malaysian Government’s commitment is evidenced by the issuance oflicenses to three foreign banks from the Middle East, namely, Kuwait Finance House,Al-Rajhi Banking and Investment Corporation, and Al-Baraka Islamic Bank, to operateas full-fledged Islamic banks in the country (Sufian and Haron, 2008). The entry of newforeign players is deemed to have a positive effect in terms of Islamic productinnovation and development, but the smaller players will now have to strive to drivebusiness volumes and establish their positions within the Islamic banking industry ascompetition intensifies (Sufian and Haron, 2008).

These developments posed great challenges to the local Islamic banks as theenvironment in which they operate has changed rapidly and consequently, impact ontheir performance. Despite the Islamic banking sector’s considerable development in

Figure 1.Islamic banking assets aspercentage of Malaysian

Banking System Assets –1996-2007

1.21.9

2.53.4

4.4

5.55.9

6.9

10.511.3

12.212.8

0

2

4

6

8

10

12

14

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

%

Source: Bank Negara Malaysia (1996-2007)

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the country, empirical works on Islamic banks’ performance are still in its infancy.The paper therefore attempts to fill the gap in the literature by providing new empiricalevidence on the impact of foreign bank entry on the performance of the MalaysianIslamic banking sector. This paper will also explore whether the De Novo foreignIslamic banks are relatively more profitable than their incumbent bank counterparts.Evidences from contemporary banking industry suggest that foreign banks indeveloping countries outperformed their domestic bank counterparts in terms ofefficiency, productivity, and profitability (Bhattacharya et al., 1997; Sathye, 2001;Hasan and Marton, 2003; Isik and Hassan, 2003; Ataullah et al., 2004). This paper willtherefore shed some light on the impact of ownership structure in determining thevariability of bank performance within the context of Malaysian Islamic bankingsector.

Various commonly used accounting-based measures of financial institutionsperformance have been gathered from the yearly financial statements of two fullyfledged domestic Islamic banks, three fully fledged foreign Islamic banks, 11 domesticbanks with Islamic windows, and four foreign banks with Islamic windows for theperiod 2001-2007. We first examine the performance of the Malaysian Islamic bankingsector by employing a series of parametric and non-parametric univariate tests beforeproceeding to examine the determinants of the Malaysian Islamic banking sector’sperformance based on multivariate analysis.

The paper is divided into six sections. The following section presents the literaturereview. Section 3 describes the data, sources, and models employed in the paper.Empirical results are presented in Section 4. The discussions on the results and policyimplications are presented in Section 5, and finally, Section 6 presents the conclusion.

2. Review of the literatureThe literature examining the performance of financial institutions has expandedrapidly in recent years. However, empirical works on the performance of the Islamicbanking sector are still in its infancy. El-Gamal and Inanoglu (2005) pointed out thatstudies on Islamic bank performance have mainly focused on theoretical issues and theempirical works have relied mainly on the analysis of descriptive statistics rather thanrigorous statistical estimations.

Although a large body of literature has examined the performance of theconventional banking sector (see surveys in Berger et al., 1993; Berger and Humphrey,1997; Berger, 2007; and references therein), more recent studies have examined theperformance of the Islamic banking sector in countries such as Sudan (Hussein, 2003;Hassan and Hussein, 2003), Turkey (El-Gamal and Inanoglu, 2004), and Malaysia(Sufian and Haron, 2008; Mokhtar et al., 2008; Sufian, 2007). Apart from focusing on aspecific country, there are also several other studies which have examined theperformance of the Islamic banking sector on a cross-country setting (Hassan et al.,2009; Sufian and Mohamad Noor, 2009; Bader et al., 2008; Ascarya and Yumanita, 2008;Viverita et al., 2007; Hassan, 2006).

While the above outlines the literature that uses advanced modelling techniques toevaluate the performance of the Islamic banking sector, there is also a growing body ofliterature that covers the determinants of Islamic banks’ performance. Such studiesinclude those byHassan andBashir (2003)who looked at the determinants of Islamic bankperformance. They concluded that Islamic banks are just as efficient as conventional

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banks based on standard accounting measures such as the cost-to-income ratio.Other studies that have used a similar approach are those by Sarker (1999) who looked atthe performance and operational efficiency of Bangladeshi Islamic banks and suggeststhat Islamic banks can survive even within a conventional banking framework. Bashir(1999) examined the risk and profitability of two Sudanese banks and results indicatethat larger Islamic banks are relativelymore profitable, but highly levered. Bashir (1999,2001) performed regression analyses to determine the underlying determinants ofperformance by Islamic banks in the Middle East. His results indicate that theperformance of banks, in terms of profits, is mostly generated from overhead, customershort-term funding, and non-interest earning assets.

Apart from those studies, there has been a paucity of research publications thatexamine the impact of entry of foreign bank on the performance of domestic Islamicbanking sector. Furthermore, to the best of our knowledge, within the context of theMalaysian Islamic banking sector, existing studies have mainly focused on theefficiency and/or productivity of the domestic Islamic banks relative to their foreignbank counterparts. In the light of these knowledge gaps, this paper seeks to provide forthe first time empirical evidence on the impact of foreign bank entry on the performanceof the Malaysian Islamic banking sector.

3. Research methodIn the spirit of maintaining homogeneity, only banks that offer Islamic bankingservices are included in the analysis. Various commonly used accounting-basedperformance measures for financial institutions are selected as variables for theempirical analysis and the data are taken from published balance sheet and incomestatement in the annual reports of each individual bank, while the macroeconomicvariables are sourced from various issues of Bank Negara Malaysia’s annual reports.

3.1 Performance measure – dependent variableFollowing Sufian (2009), Ben Naceur and Goaied (2008), and Kosmidou (2008), thedependent variable used in this paper is return on assets (ROA)[2]. ROA shows theprofit earned per dollar of assets and most importantly reflects management’s ability toutilize the bank’s financial and real investment resources to generate profits (Hassanand Bashir, 2003). For any bank, the ROA depends on the bank’s policy decisions aswell as uncontrollable factors relating to the economy and government regulations.Rivard and Thomas (1997) suggest that bank’s profitability is best measured by ROAas it is not distorted by high equity multipliers and represents a better measure of theability of the firm to generate returns on its portfolio of assets. ROE, on the other hand,reflects how effectively a bank management is in utilizing its shareholders’ funds.Hassan and Bashir (2003) highlight that bank normally utilizes financial leverageheavily to increase ROE to competitive levels.

3.2 Internal determinantsBank-specific variables included in the regression models are LOANS/TA (total loansdivided by total assets), LNTA (log of total assets), LLP/TL (loan loss provisionsdivided by total loans), NIE/TA (total overhead expenses divided by total assets),EQASS (book value of stockholders’ equity as a fraction of total assets), and LNDEPO(log of total deposits).

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The LNTA variable is included in the regression as a proxy of size to capture thepossible cost advantages associated with size (economies of scale). In the literature,mixed relationships are found between size and profitability, while in some cases aU-shaped relationship is observed. LNTA is also used to control for cost differencesrelated to bank size and ability of larger banks to diversify. In essence, LNTAmay leadto positive effects on banks’ profitability if there are significant economies of scale.On the other hand, if increased diversification leads to higher risks, the variable mayexhibit negative effects.

EQASS variable is included in the regression models to examine the relationshipbetween profitability and bank capitalization. Strong capital structure is essential forbanks in developing economies since it provides additional strength to withstandfinancial crises and increases safety for depositors during unstable macroeconomicconditions. Furthermore, lower capital ratios in banking imply higher leverage and risk,and therefore greater borrowing costs. Thus, the profitability level should be higher forbanks that are better capitalized.

The ratio of LLP/TL is incorporated as an independent variable in the regressionanalysis as a proxy for credit risk. The coefficient of LLP/TL is expected to be negativebecause bad loans are expected to reduce profitability. Miller and Noulas (1997) suggestthat the greater the exposure of the banks to high risk loans, the higher would be theaccumulation of unpaid loans and the lower the level of profitability. Miller and Noulas(1997) further suggest that decline in LLP are inmany instances the primary catalyst forincreases in profit margins. Thakor (1987) suggests that the level of LLP is an indicationof the bank’s asset quality and signals changes in future performance.

The ratio of NIE/TA is used to provide information on the variations of bankoperating costs. The variable represents total amount of wages and salaries as well asthe costs of running branch office facilities. The relationship between the NIE/TAvariable and profitability levelsmaybe negative because banks that aremore productiveand efficient should keep their operating costs low. Furthermore, the usage of newelectronic technology like ATMs and other automated means of delivering services mayreduce expenses on wages (as capital is substituted for labour).

An important decision that managers of Islamic banks need to consider in relation toliquidity management is in terms of determining their needs and managing the processof deposits and loans. Hence, the ratio of LOANS/TA is used as a measure of liquiditywith higher figures denoting lower liquidity. Without the required liquidity andfunding to meet obligations, a bank may fail. Thus, in order to avoid insolvencyproblems, bank often hold liquid assets which can be easily converted to cash. However,liquid assets are usually associated with lower rates of return. It would therefore bereasonable to expect higher liquidity to be associated with lower bank profitability.

The variable LNDEPO is included in the regression model as a proxy variable forbranch networks. Islamic banks with more branch networks are able to attract moredeposits and will have access to cheaper source of funds. Chu and Lim (1998) in theirstudy suggest that large banks may attract more deposits and loan transactions and inthe process command larger interest rate spreads. On the other hand, smaller bankinggroups with smaller base of depositors may have to resort to purchasing funds in theinter-bank market which is often costlier (Randhawa and Lim, 2005). However, giventhat small banks have smaller base of depositors, they will thus have lesser deposits to

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transform into loans and would be in a better position to attain higher efficiency levelscompared to their larger counterparts (Randhawa and Lim, 2005).

3.3 External determinantsIf analysis is done in a static setting, they may fail to capture developments in theregulatory environment and in the marketplace, which may have changed due to theunderlying production technology and the associated production functions.Furthermore, different forms of banking would react to environmental changesdifferently. Hence, the change in the financial landscape and structure may vary acrossbanking groups (Saunders et al., 1990; Button and Weyman-Jones, 1992; Berger et al.,1995). To test the relationship between economic and market conditions and Islamicbank profitability, the variables LNGDP (natural log of gross domestic product) andINFL (the annual inflation rate) are used as proxies.

GDP is among the most commonly used macroeconomic indicator to measure totaleconomic activity within an economy. The GDP is expected to influence numerousfactors related to the supply and demand for loans and deposits. The macroeconomicconditions may have either pro or counter cyclical impacts on bank profitability levels.

Another important macroeconomic condition which may affect both the costs andrevenues of banks is the inflation rate (INFL). Staikouras and Wood (2003) point outthat inflation may have direct (increase in the price of labour) and indirect (changes ininterest rates and asset prices) effects on the profitability of banks. Perry (1992)suggests that the effects of inflation on bank performance depend on whether theinflation is anticipated on unanticipated. In the anticipated case, the interest rates areadjusted accordingly resulting in revenues increasing faster than costs whichsubsequently results in a positive impact on bank profitability. On the other hand, inthe unanticipated case, banks may be slow in adjusting their interest rates resulting in afaster increase of bank costs than bank revenues, consequently having negative effectson bank profitability[3].

Table I lists the variables used as proxy for profitability and its determinants.We also include the notation and the expected effect of the determinants according tothe literature.

Table II presents the summary statistics of the dependent and the explanatoryvariables for the four types of Islamic banks in panels A, B, C, and D. During the periodunder study, on average, the domestic Islamic windows banks seem to be moreprofitable and less liquid. On the other hand, the fully fledged domestic Islamic banksare relatively larger, have extensive branch networks, and incur a higher amount ofprovisions for loan losses. It can be observed from panel D of Table II that the fullyfledged foreign Islamic banks incur a higher level of overhead expenses and are bettercapitalized compared to other types of Malaysian Islamic banks.

3.4 Model specificationTo test the relationship between profitability of Islamic banks and the internal andexternal determinants described earlier, we estimate a linear regression model in thefollowing form:

Yjt ¼ dt þ a 0jt X ijt þ a 0

it Xejt þ 1jt ð1Þ

where j ¼ an individual Islamic bank.

t ¼ refers to year.

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yjt ¼ the ROA of Islamic bank j in a particular year t.

Xi ¼ the internal factors (determinants) of an Islamic bank.

Xe ¼ the external factors (determinants) of an Islamic bank.

e jt ¼ normally distributed random variable disturbance term.

Extending equation (1) to reflect the variables as described in Table I, the baselineregression model is formulated as follows:

yit ¼ dt þ ajtðLNTAjt þ EQASSjt þ LLP=TLjt þ NIE=TAjt þ LOANS=TAjt

þ LNDEPOjtÞ þ aitðLNGDPt þ INFLtÞ þ 1jt ð2Þ

We apply the least square method of fixed effects model (FEM) to control forbank-specific effects, while the standard errors are calculated using White’s (1980)

Variable Description

Hypothesizedrelationship

with profitability

DependentROA The return on average total assets of the bank in year t NAIndependentInternal factorsLOANS/TA A measure of liquidity, calculated as total loans/total

assets. The ratio indicates what percentage of theassets of the bank is tied up in loans in year t –

LNTA The natural logarithm of the accounting value of thetotal assets of the bank in year t. This is a proxy forsize of bank þ /2

LLP/TL Loan loss provisions/total loans. An indicator ofcredit risk, which shows how much a bank isprovisioning in year t relative to its total loans –

NIE/TA Calculated as non-interest expense/total assets andprovides information on the efficiency of themanagement regarding expenses relative to theassets in year t. Higher ratios imply a less efficientmanagement –

LNDEPO LNDEPO is a proxy measure of networkembeddedness, calculated as the log of total deposits þ /2

EQASS A measure of bank’s capital strength in year t,calculated as equity total assets. High capital assetratio is assumed to be indicator of low leverage andtherefore lower risk þ /2

External factorsLNGDP Natural logarithm of gross domestic products. It is

an indicator of economic condition þ /2INFL The rate of inflation þBank ownershipDENOVO A dummy variable that takes a value of 1 for De

Novo banks, 0 otherwise þPeriodPOST A dummy variable that takes a value of 1 for the

post-entry period, 0 otherwise þ

Table I.Descriptive ofthe variables usedin the regression models

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transformation to control for cross section heteroscedasticity. By using panel data,FEM produces unbiased and consistent estimates of the coefficients ( Jeon and Miller,2005). FEM assumes that differences across Islamic banks reflect the parametric shiftsin the regression equation. Such an interpretation becomes more appropriate when thewhole population rather than a sample from it is used ( Jeon and Miller, 2005). Since thesample considers all Malaysian Islamic banks over a particular time period, FEM isadopted in the analysis. Furthermore, the use of an FEM rather than a random effectsmodel (REM) has been tested with the Hausman test. To ensure robustness, empiricaltesting is also performed using the least square method of REM.

Table III provides information on the degree of correlation between the explanatoryvariables used in the multivariate regression analysis. The matrix shows that thecorrelation between the Islamic bank-specific variables is not strong suggesting thatmulticollinearity problems are not severe or non-existent. Kennedy (2008) points outthat multicollinearity is a problem when the correlation is above 0.70, which is not thecase here.

4. Empirical findingsIt is of public interest to knowwhat Islamic banks can do to improve their profitability sothat scarce resources are allocated to their best use and not wasted during the productionof services and goods (Isik and Hassan, 2003). For this purpose, we investigate whetherany aspects of the Islamic banks are related to their degree of profitability. In the precedinganalysis, we will discuss the performance of the Malaysian Islamic banking sector based

Ratios ROA LOANS/TA LNTA LLP/TL NIE/TA EQASS LNDEPO

Measures Profitability Liquidity Size Credit risk EfficiencyCapitalstrength

Branchnetworks

Panel A: domestic IBS banks (n ¼ 11)Mean 1.4632 59.1486 6.5219 1.6228 0.5105 9.1233 6.427Minimum 21.2464 8.7893 5.5871 20.6857 0.0336 3.2242 5.493Maximum 5.0372 93.6017 7.3644 5.6352 2.9924 27.2034 7.267SD 0.9590 19.5335 0.4374 1.3669 0.6178 4.8222 0.411Panel B: foreign IBS banks (n ¼ 4)Mean 1.1976 41.3510 6.0006 0.8590 0.4972 10.7284 5.851Minimum 20.3839 1.0547 4.9687 20.3602 0.0545 1.2167 4.794Maximum 4.0143 94.1705 6.7302 2.9049 1.7022 30.0905 6.609SD 1.0463 28.0420 0.5571 0.8228 0.4294 7.6146 0.550Panel C: fully fledged domestic Islamic banks (n ¼ 2)Mean 0.0853 47.4905 6.9015 1.9926 1.1587 8.1503 6.836Minimum 28.8767 1.1964 5.7170 0.0031 0.0938 21.9019 5.636Maximum 1.9160 79.6418 7.3784 15.1813 3.4752 28.8695 7.257SD 2.0108 17.4990 0.3013 2.8318 0.6262 5.0825 0.314Panel D: fully fledged foreign Islamic banks (n ¼ 3)Mean 24.8720 26.4835 6.6582 1.4979 5.1379 36.9612 6.348Minimum 225.7787 0.0000 5.4645 0.0000 0.4527 11.8537 4.622Maximum 0.3226 73.4665 9.0979 2.7710 26.0090 77.1810 8.953SD 10.3625 29.9956 1.2965 0.8896 10.2394 30.9449 1.518

Note: The table presents the summary statistics of the variables used in the regression analysis

Table II.Summary statisticof dependent and

explanatory variables

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on the results derived from a series of parametric and non-parametric tests, beforediscussing the results of the multivariate regression.

4.1 Performance of the De Novo banks relative to the incumbent banksTo examine the differences in the relative performance between the De Novo and theincumbent banks, a series of parametric (t-test) and non-parametric (Mann-Whitney(Wilcoxon) and Kolmogorov-Smirnov) tests were conducted and the results arepresented in Table IV.

The results from the parametric t-test suggest that the incumbent banks are relativelymore profitable (ROA) than the De Novo banks and is statistically significant at the1-percent level (0.64692 . 24.87202). The De Novo banks are found to incur relativelyhigher operating costs (NIE/TA), disburse lower amount of loans (LOANS/TA), and arebetter capitalized (EQASS). The empirical findings also suggest that the De Novo banksare relatively smaller (LNTA) and have lower credit risk (LLP/TL). The results fromthe parametric t-test are further confirmed by the non-parametric Mann-Whitney(Wilcoxon) and Kolmogorov-Smirnov tests.

4.2 Implications of foreign banks entry on the performance of the incumbent banksIn the preceding analysis, the difference in the performance of the Malaysian Islamicbanking sector between the two periods, i.e. before and after the entry of foreign banks,will be examined. A series of parametric (t-test) and non-parametric (Mann-Whitney(Wilcoxon) and Kolmogorov-Smirnov) tests are conducted and the results are presentedin Table V.

The results from the parametric t-test suggest that the Malaysian Islamic bankingsector exhibits lower profitability (mean ROA) in the post-entry period(0.01012 , 0.1.27616) and it is statistically significant at the 5-percent level ( p ¼ 0.022).The results indicate that Malaysian Islamic banks are relatively larger (LNTA) in the

Independentvariables LNTA EQASS LLP/TL NIE/TA LOANS/TA LNDEPO LNGDP INFL

LNTA 1.000 20.154 0.191 * 0.091 0.257 * * 0.698 * * 0.400 * * 0.250 * *

EQASS 1.000 0.029 0.318 * * 0.341 * * 20.174 0.125 0.065LLP/TL 1.000 0.054 0.101 0.182 0.077 20.005NIE/TA 1.000 0.124 0.129 0.125 0.113LOANS/TA 1.000 0.250 * * 0.021 20.008LNDEPO 1.000 0.359 * * 0.203 *

LNGDP 1.000 0.675 * *

INFL 1.000

Notes: Significance at: *5 and * *1 percent levels. The table presents the results from Spearman rcorrelation coefficients. The notation used in the above table is defined as follows: LNTA is a proxymeasure of size, calculated as a natural logarithm of total bank assets; EQASS is a measure ofcapitalization, calculated as book value of shareholders equity as a fraction of total assets; LLP/TL is ameasure of bank risk calculated as the ratio of total loan loss provisions divided by total loans; NIE/TA is a proxy measure for management quality, calculated as personnel expenses divided by totalassets; LOANS/TA is used as a proxy measure of loans intensity, calculated as total loans divided bytotal assets; LNDEPO is a proxy measure of branch networks, measured by the natural logarithm oftotal bank deposits; LNGDP is natural log of gross domestic products; INFL is the inflation rate

Table III.Correlation matrix forthe explanatory variables

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TestgroupsNon-param

etrictest

Param

etrictest

t-test

Mann-W

hitney

(Wilcoxon

rank-sum)

Kolmogorov-Smirnov

(K-S)test

Individual

tests

t(Prb

.t)

test

z(Prb

.z)

Distribution

I¼

Distribution

DN

Measures

Teststatistics

Mean

tMeanrank

zK-S

(Prb

.K-S)

Profitability

ROA

Incumbentbanks

0.64692

3.448**

29.07

23.380**

1.903**

DeNovobanks

24.87202

6.83

Efficiency

NIE/TA

Incumbentbanks

0.72724

–25.39

0.144

0.952

DeNovobanks

5.13787

3.089**

35.00

Capital

strength

EQASS

Incumbentbanks

9.02588

–23.89

0.001**

1.853**

DeNovobanks

36.96123

5.830**

46.50

Size

LNTA

Incumbentbanks

6.73217

0.306

27.54

21.375

1.085

DeNovobanks

6.65819

18.50

Liquidity

LOANS/TA

Incumbentbanks

51.76382

2.545*

28.11

22.119*

1.185

DeNovobanks

26.48353

14.17

Creditrisk

LLP/TL

Incumbentbanks

1.70300

0.206

26.07

20.573

0.968

DeNovobanks

1.49787

29.83

Branch

networks

LNDEPO

Incumbentbanks

6.39152

0.162

55.89

20.672

0.704

DeNovobanks

6.34750

47.83

Note

s:Significance

at:* 5

and

** 1

percentlevels,respectively;testmethodologyfollow

sam

ongothers,Aly

etal.(1990),E

lyasianiandMehdian(1992),

andIsikandHassan(2002);param

etric(t-test)andnon-param

etric(M

ann-W

hitney

andKolmogorov-Smirnov)teststestthenullhypothesisofequalmean

betweenthetw

omodels

Table IV.Summary of parametricand non-parametric tests

for incumbentand De Novo banks

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Testgroups N

on-param

etrictest

Param

etrictest

t-test

Mann-W

hitney

(Wilcoxon

rank-sum)test

Kolmogorov-Smirnov

(K-S)test

Individual

tests

t(Prb

.t)

z(Prb

.z)

Distribution

PR

E¼

Distribution

PO

ST

Measures

Teststatistics

Mean

tMeanrank

zK-S

(Prb

.K-S)

Profitability

ROA

Pre-entryperiod

1.27616

2.317*

62.92

22.246*

1.238

Post-entryperiod

0.01012

49.10

Efficiency

NIE/TA

Pre-entryperiod

0.66223

21.227

52.50

21.400

1.245

Post-entryperiod

1.23616

61.12

Capital

strength

EQASS

Pre-entryperiod

9.46054

21.385

53.63

21.003

1.015

Post-entryperiod

12.24919

59.81

Size

LNTA

Pre-entryperiod

6.30724

23.865**

46.35

23.553**

1.766**

Post-entryperiod

6.72363

68.21

Liquidity

LOANS/TA

Pre-entryperiod

50.67571

0.406

56.68

20.064

0.602

Post-entryperiod

48.84686

56.29

Creditrisk

LLP/TL

Pre-entryperiod

1.38980

20.845

55.22

20.449

0.589

Post-entryperiod

1.67933

57.98

Branch

networks

LNDEPO

Pre-entryperiod

6.21948

23.115**

47.73

23.072**

1.563*

Post-entryperiod

6.58494

66.63

Note

s:Significance

at:* 5

and

** 1

percentlevels,respectively;testmethodologyfollow

sam

ongothers,Aly

etal.(1990),E

lyasianiandMehdian(1992),

andIsikandHassan(2002);param

etric(t-test)andnon-param

etric(M

ann-W

hitney

andKolmogorov-Smirnov)teststestthenullhypothesisofequalmean

betweenthetw

omodels

Table V.Summary of parametricand non-parametric testsfor pre-entry andpost-entry periods

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post-entry period and it is statistically significant at the 1-percent level. In the post-entryperiod, the Malaysian Islamic banking sector’s operating costs (NIE/TA), level ofcapitalization (EQASS), and credit risk (LLP/TL) are also found to be relatively higheralthough the difference is not statistically significant. On the other hand, the MalaysianIslamic banking sector disbursed relatively lower amount of loans (LOANS/TA) duringthe post-entry period but is not statistically significant. The results from the parametrict-test are further confirmed by the non-parametric Mann-Whitney (Wilcoxon) andKolmogorov-Smirnov tests.

4.3 Factors influencing the performance of Islamic banks in MalaysiaThe regression results focusing on the relationship between bank profitability and theexplanatory variables are presented in Table VI based on the FEM and the REM.The model performs reasonably well with most variables remaining stable across thevarious regressions tested. The explanatory power of the models is also reasonablyhigh, while the F-statistics for all models is significant at the 1-percent level except forModel 1 based on REM.

Results based on both FEM and REM indicate that size (LNTA) is positively relatedto Islamic banks’ performance and is statistically significant at the 5-percent level orbetter. Hauner (2005) offers two potential explanations for which size could have apositive impact on bank performance. First, if it relates to market power, large banksshould pay less for their inputs. Second, there may be increasing returns to scalethrough the allocation of fixed costs (e.g. research or risk management) over a highervolume of services or from efficiency gains from a specialized workforce.

The empirical findings suggest that the level of capitalization (EQASS) is negativelyrelated to Islamic banks’ profitability and is statistically significant inModels 1 and 2 ofthe REM regressions. The results are consistent with, among others, Akhigbe andMcNulty (2005), suggesting that, ceteris paribus, more profitable banks will use lessequity (more leverage) compared to its less profitable counterparts. The results indicatethat less profitable banks are involved in riskier operations and in the process tend tohold more equity, voluntarily or involuntarily, i.e. as part of the banks’ deliberate effortsto increase safety cushions and in turn decrease the cost of funds, or perhapsresponding to regulatory pressures that mandate riskier banks to have more equity.

As expected, Islamic banks’ performance is negatively related to credit risk (LLP/TL)and is statistically significant at the 1-percent level based on FEM but at the10-percent level based onREM, suggesting that Islamic bankswith higher credit risk tendto exhibit lower profitability levels. The result is in consonance with Berger andDeYoung’s (1997) “bad management” hypothesis which predicts that bank performancewill be impacted by non-performing loans since inefficient bankmanagers do not monitorloan portfolios efficiently. The results imply that Malaysian Islamic banks shouldfocus more on credit risk management, which has been proven to be problematic in therecent past. Serious banking problems have arisen from the failure of financialinstitutions to recognize impaired assets and to create reserves forwriting off these assets.

With regard to efficiency of managing expenses (NIE/TA), results based on REMindicate a negative and significant impact on the profitability of Malaysian Islamicbanks. The results imply that an increase (decrease) in these expenses reduces(increases) the profits of Islamic banks operating in Malaysia. Pasiouras and Kosmidou(2007) and Kosmidou (2008) have also found poor management of expenses to be among

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FEM

REM

Explanatoryvariables

Model1

Model2

Model1

Model2

Model3

CONSTANT

524.8765

**

887.1778

***

384.2133

**

660.9033

***

359.7538

**

(2.230238)

(6.816864)

(2.382330)

(3.854137)

(2.062382)

Bank

char

act

eris

tics

LNTA

26.82213

***

28.16320

***

17.23570

***

17.82015

**

17.50034

***

(size)

(2.763024)

(2.683664)

(2.671804)

(2.617396)

(2.630418)

EQASS

20.090670

20.100355

20.279539

***

20.291165

***

20.158237

(capital

strength)

(20.666786)

(20.774127)

(22.763525)

(22.947730)

(21.279780)

LLP/TL

24.661631

***

24.840928

***

23.880163

*24.006371

*23.858162

*

(creditrisk)

(23.134260)

(23.390990)

(21.673262)

(21.773184)

(21.646464)

NIE/TA

20.145782

0.008818

20.918892

***

20.827166

***

20.871968

***

(efficiency)

(20.839282)

(0.044236)

(24.034560)

(23.628880)

(23.406887)

LOANS/TA

20.000481

0.012299

0.021730

0.027830

20.001941

(liquidity)

(20.006537)

(0.170333)

(0.332678)

(0.424512)

(20.025682)

LNDEPO

211.29482

**

211.99927

**

213.68625

**

214.14530

**

212.71809

(networks)

(22.367554)

(22.272290)

(22.503758)

(22.512807)

(22.162131)

Eco

nom

icco

ndit

ions

LNGDP

248.69832

**

278.23382

***

231.18184

**

253.53527

***

229.77565

**

(econom

iccondition)

(22.268318)

(26.887699)

(22.240744)

(23.977949)

(22.039036)

INFL

23.852227

211.85000

**

22.702060

28.895512

*22.989458

(inflationrate)

(20.982470)

(22.403106)

(20.832178)

(21.929539)

(20.821585)

Period

POST

11.76193

***

9.185011

**

(tim

e)(2.647714)

(1.983752)

Bank

owner

ship

DENOVO

212.08669

(typeof

ownership)

(21.475179)

R2

0.606699

0.620471

0.289393

0.300513

0.306601

Adjusted

R2

0.484963

0.497010

0.233659

0.238182

0.244813

D.W

.statistics

1.900524

1.942151

5.192403

***

1.369451

1.388381

F-statistic

4.983723

***

5.025642

***

1.359679

4.821281

***

4.962138

***

Note

s:Significance

at:* 10,

** 5

and

*** 1

percentlevels,respectively;values

inparentheses

are

t-statistics:

RO

Ajt¼

aþ

b1L

NT

Aþ

b2E

QA

SS

jtþ

b3L

LP=T

Lþb4N

IE=T

Ajtþb5L

OA

NS=T

Aþ

b6L

ND

EP

Oþd7L

NG

DtP

þd8IN

FL

tþg9D

EN

OV

Ojtþz 1

0P

OS

Ttþ

1j

Thedependentvariable

isROA

calculatedas

net

profitdivided

bytotalassets;LNTA

isaproxymeasure

ofsize,calculatedas

anaturallogarithm

oftotalbankassets;EQASSis

ameasure

ofcapitalization,calculatedas

bookvalueof

shareholdersequityas

afraction

oftotalassets;L

LP/TLisameasure

ofbankrisk

calculatedas

theratioof

totalloan

loss

provisionsdivided

bytotalloans;

NIE/TAisaproxymeasure

forcost,calculatedas

personnelexpensesdivided

bytotalassets;LOANS/TAisusedas

aproxymeasure

ofloansintensity,calculatedas

totalloansdivided

bytotalassets;

LNDEPOisaproxymeasure

ofnetworkem

beddedness,calculatedas

thelogof

totaldeposits;LNGDPisnaturallogof

gross

dom

esticproducts;INFListherate

ofinflation.DENOVOisadummy

variablethat

takes

avalueof

1forDeNovoIslamicbanks,0otherwise;POSTisadummyvariablethat

takes

avalueof

1forthepost-entryperiodof

theDeNovobanks,0otherwise

Table VI.Panel regression analysis

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the main contributors to poor profitability. Clearly, efficient cost management is aprerequisite for improved profitability of the Malaysian Islamic banking sector.Furthermore, the Malaysian Islamic banking sector has not reached the maturity levelrequired to link quality effects from increased spending to higher profitability.

The proxy for market power (LNDEPO) reveals a negative relationship betweenbanks’ profitability levels and individual Islamic bank’s deposits, suggesting that themore profitable banks are those with lower market share, thus diminishing the marketleadership argument. The results imply that Islamic banks with small market share,like the foreign Islamic banks, can be as profitable as the banks with a significantmarket share because maintaining or expanding market share might involve extracosts resulting in lower profitability.

The impact of macroeconomic conditions (LNGDP) on ROA is negative in all cases.Consistent with the findings by Kosmidou (2008) and Staikouras et al. (2008), theempirical findings seem to suggest that INFL is negatively related to Malaysian Islamicbanks’ profitability implying that during the period under study, inflation is unexpectedand thus results in higher increase in costs compared to revenues. In this vein,Staikouras andWood (2003) pointed out that inflationmay have direct effects (e.g. rise inthe price of labour).

To investigate the effects of the entry of the foreign Islamic banks on theperformance of the Malaysian Islamic banking sector, a binary dummy variable,DUMPOST, is introduced as an explanatory variable in Model 2 regression. It can beseen in columns 2 and 4 of Table VI that the Malaysian Islamic banking sector has beenrelativelymore profitable in the post-entry period compared to the pre-entry period. Theempirical findings seem to suggest that competition has resulted in a more competitiveMalaysian Islamic banking sector, thus providing support to the industrial organizationliterature. According to the industrial organization literature, a positive impact isexpected under both the collusion and the efficiency views (Goddard et al., 2001).

Islamic banks of different ownership forms may react differently to the profitabilityvariable. Thus, in the preceding analysis, we repeat equation (1) above to examinefactors that influence the profitability of the De Novo foreign Islamic banks. The resultsare presented in column 5 of Table VI. It can be seen that the profitability of the De Novoforeign Islamic banks are relatively lower compared to their incumbent Islamic bankcounterparts but is not statistically significant. The result could be attributed to thedifferent levels of knowledge of the market between the incumbent and the De Novoforeign Islamic banks. Furthermore, De Young and Hasan (1998) suggest that De Novobanks take about nine years to reach the established banks’ efficiency levels. However,the results should be interpreted with caution since the coefficient of the variable is notstatistically significant.

5. Discussion and policy implicationsThe move by the Central Bank of Malaysia to bring forward the liberalization of theIslamic banking sector by announcing in September 2003 the issuance of three newIslamic banking licenses to foreign Islamic banking players augurs well in terms ofinnovation and development of Islamic banking products and services[4]. The newforeign fully fledged Islamic banks may have advantages stemming from their wideinternational presence tomobilize Islamic banking funds from theMiddle East aswell asthe dynamism and innovativeness in introducing and promoting new Islamic banking

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and finance products to cater for the needs of the domestic market. They may alsopossess inherent economies of scale, as a direct extension of their other internationaloperations and so are capable of competing with the incumbent banks.

From the policy-making perspective, the opening up of the Malaysian Islamicbanking sector to foreign banks entry is deemed important in the on-going process ofimproving efficiency and productivity as well as innovation. However, as competition isexpected to intensify, the smaller domestic as well as the foreign Islamic banks willhave to work harder to increase their productivity and efficiency in order to remaincompetitive, profitable, and most importantly, to survive.

The intensification of competition is expected to render the issue of increasing theefficiency, productivity, and profitability of the Malaysian Islamic banking sector asone of the main priorities for the regulators. In this vein, the earlier studies by Bergerand Humphrey (1992), Barr and Siems (1994), and Wheelock and Wilson (1995) havefound that failing banks tend to have low cost efficiency prior to their failure and arelikely to be located far from the best practice frontiers. Within the context of theMalaysian Islamic banking sector, the findings from this paper clearly bring forth theimportance of cost and risk management practices. Therefore, it is reasonable tosuggest that in order to remain profitable, Malaysian Islamic banks should seriouslyconsider minimizing their operating costs and credit risk without having to forego thelegitimacy of its operations from the syariah point of view (Sufian and Haron, 2008).

To prepare the incumbent banks for stiffer competition from the foreign fullyfledged Islamic banks, the Central Bank of Malaysia has encouraged the domesticbanking groups to establish their wholly owned Islamic banking subsidiaries. Duringthe period under study, apart from Maybank and Public Bank which continue to offerIslamic banking services under the “window approach”, all the other local bankinggroups have now incorporated Islamic banking subsidiaries. To this end, the foreignbanks have also expressed their interests to launch Islamic banking subsidiaries. Thisbodes well as the findings from the study clearly suggest that size is an important andsignificant determinant of Islamic bank profitability within the context of theMalaysian Islamic banking sector. Therefore, by increasing the size of their operations,the smaller Islamic banks, particularly the De Novo foreign Islamic banks, may benefitfrom the increase in the scale of their operations.

In contrast to the “window” structure, where Islamic banking operations residewithin the conventional banking entity, the incorporation of the Islamic bankingsubsidiary also provides opportunities to potential institutional investors, both domesticand foreign alike, to participate in this activity through direct equity participation. Theliberalized shareholding policy in the Islamic Banking Scheme, where foreign investorscan now own up to 49 percent equity, will increase the potential to build strategicpartnerships to acquire new expertise, tap the best international talents, and developnew value-added activities that would enhance competitiveness and stimulate greaterinnovation in the industry.

The establishment of Islamic banking subsidiaries may also prove to be fruitful tomany parties concerned. As Islamic banking subsidiaries come under the governance ofthe Islamic Banking Act (1983) rather than the Banking and Financial InstitutionsAct (1989), it will remove most of the impediments preventing Islamic bankingwindows to participate in non-traditional banking business such as wholesale and retailtrading, purchase of assets and landed properties, as well as purchases of equities via

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joint venture and portfolio investments. Malaysian Islamic banks can now underwriteIslamic bonds and stocks in addition to providing fee-based business such as brokerageand unit trusts.

6. Concluding remarks and directions for future researchThis paper seeks to examine the determinants of the profitability of the MalaysianIslamic banking sector during the period from 2001 to 2007. The empirical findings ofthis paper suggest that overhead costs, capitalization, market share, and credit risk arenegatively related to Malaysian Islamic banks’ profitability. On the other hand, Islamicbanks which are larger tend to be more profitable. The empirical findings from thispaper suggest that the Malaysian Islamic banking sector’s profitability has beenrelatively higher in the post-entry period compared to the pre-entry period. The De NovoIslamic banks are found to be relatively less profitable than their incumbent bankcounterparts, which could be attributed to the different levels of knowledge of themarket between the incumbent and the De Novo Islamic banks.

The empirical findings from this paper have considerable policy relevance. It could beargued that the more profitable Islamic banks will be able to offer more new products andservices. To this end, the role of technology advancement is particularly important giventhat Islamic banks with relatively more advanced technologies may have addedadvantage over its peers. The continued success of the Malaysian Islamic banking sectordepends on its efficiency, profitability, and competitiveness. Furthermore, in view of theincreasing competition attributed to the more liberalized Islamic banking sector, bankmanagements as well as policymakers will be more inclined to find ways to obtain theoptimal utilization of capacities as well asmaking the best use of their resources to ensurethat they are not wasted during the production of banking products and services.

Moreover, the ability to maximize risk-adjusted returns on investment and to sustainstable and competitive returns are important elements in ensuring the competitivenessof the Malaysian Islamic banking sector. Thus, from the regulatory perspective, theperformance of the Islamic banking sector will be based on their efficiency, productivity,and profitability. Therefore, the policy direction will be focused on enhancing theresilience and efficiency of the Islamic banking institutions with the aim of intensifyingthe robustness and stability of the Islamic banking sector.

Future research could include more variables such as taxation and regulationindicators, exchange rates as well as indicators of the quality of services offered.Another possible extension could be the examination of differences in the determinantsof profitability between small and large or high and low profitability banks. In terms ofmethodology, a statistical cost accounting and/or frontier optimization techniques suchas the non-parametric data envelopment analysis, the stochastic frontier analysis,and/or the Malmquist productivity index approach are recommended to examine theimpact of the entry of foreign banks on the efficiency and productivity of the MalaysianIslamic banking sector.

Notes

1. The first country with a dual banking system was the United Arab Emirates where DubaiIslamic Bank was established in 1973 with a paid-up capital of US$14 million (Metwally,1997).

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2. The ROA is a widely used measure of bank profitability by policymakers and bankmanagements and is derived by dividing profit after tax by TA. Likewise, the ROE is also awidely used bank profitability measure and is derived by dividing profit after tax byshareholders equity.

3. Income of Islamic banks must not be contaminated by usury (riba’). Riba’ the Englishtranslation of which is usury, is prohibited in Islam and is acknowledged by all Muslims.The prohibition of riba’ is clearly mentioned in the Quran, Islam’s holy book and thetraditions of Prophet Muhammad (sunnah). The Quran states: “Believers! Do not consumeriba’, doubling and redoubling [. . .]” (3.130); “God has made buying and selling lawful andriba’ unlawful [. . .]” (2:274). Thus, in the case of the Malaysian Islamic banking sector, it isreasonable to expect the interest rate to be the profit rate.

4. In September 2003, the Central Bank of Malaysia announced the issuance of three newIslamic banking licenses to foreign Islamic financial institutions from the Middle East underthe Islamic Banking Act (1983). Following this, the first fully fledged foreign Islamic bank,Kuwait Finance House started operations in August 2005. The other two Islamic banks,namely Saudi Arabia-based Al-Rajhi Bank and Qatar Islamic Bank, started operations in2006 and early 2007, respectively. Under the Islamic Banking Act (1983), the new foreignIslamic banks are allowed to conduct a wide range of Islamic banking business in Malaysia.They are required to meet the minimum paid-up capital of RM10 million and will have to payan annual license fee of RM50,000.

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Corresponding authorFadzlan Sufian can be contacted at: fadzlan.sufian@khazanah.com.my

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