Islamic banking is simply a banking activity focused on Islamic principles which do not permit the disbursement and receiving of Riba and encourages sharing of profit in the banking business. According to the latest quarterly edition of State Bank of Pakistan's "Islamic Banking Bulletin", the total Shariah-compliant assets throughout the world have grown to around US$ 700 billion with yearly growth exceeding 10.0 percent during the past decade and are projected to reach US$ 1.6 trillion by 2012. Pakistan's Islamic banking industry was launched in 2008 in Pakistan. The SBP's strategic plan aims to enlarge the size of this industry to 12 percent of Pakistan's total banking assets by 2012.
Islamic financial institutions do not only play a vital role in resource mobilization, resource allocation and employment but are also actively involved in the course of implementing government monetary policy. Other than offering nearly all traditional banking facilities, Islamic banks also assist domestic and international trades.
1.2 Problem Statement
Studies that assess the influence of various factors that determine Islamic banks profitability are still at initial stage. Few attempts have up till now been made to empirically analyze the Islamic banks' performance. In the Islamic banking literature, the work of Haron (1996a) was the first attempt to examine factors that contributed towards Islamic banks' profitability. Most of the research used multiple regression analysis technique in measuring the relationship among the determining factors and profitability ratios. Extending the previous work in Islamic banks' performance, this thesis examined the strength of relationship between Investment deposit variable and profitability of Islamic banks using univariate regression methodology.
1.3 Hypothesis
This thesis attempted to test only one hypothesis. According to Becker (1995), hypothesis testing is the process of judging which of two contradictory statements is correct.
Hypothesis : Investment Deposits increase the profitability of Islamic banks.
1.4 Outline of the study
This thesis is divided into seven chapters. After a brief introduction in Chapter1, the literature review on determinants of Islamic bank performance is highlighted in chapter 2. Chapter 3 examines the methodology used in analyzing the relationship between the investment deposit variable used in this study and the performance of Islamic banks. Chapter 4 presents the findings and interpretation of the results while conclusion, discussion and implications are presented in chapter 5.
CHAPTER 2:
LITERATURE REVIEW
The whole foundation of Islamic Finance is that the two sides of the equation (i.e. the fund-providers and the fund-users) work in agreement as partners, without depositors being assured of any return from those who use their money. In practice, Islamic banks draw approximately three-quarters of the capital from their depositors, and do not guarantee any precise level of return to these fund-providers. (Shubber and Alzafri,2008).
Ghafoor (1995) stated that all Islamic banks possess three types of deposit accounts titled current, savings & investment account. Current account or demand deposit accounts function in the same manner in all the conventional banks. Deposit money is assured. Savings deposit accounts work in different ways. In some of the banks, the depositors permit the banks to make use of their money but they attain a guarantee of being paid the complete amount back from the bank. Banks adopt a number of methods of inducing their customers to deposit with them, but profit is not promised. In others, savings accounts are regarded as investment accounts but with less strict conditions to withdrawals & minimum balance. The deposit money is not assured but the banks take care to invest capital from such accounts in fairly risk-free short-term projects. Therefore, lower profit rates are anticipated and that too only on a section of the average minimum balance on the view that a high level of reserve funds need to be deposited at all times to meet up withdrawal demands. Contrastingly, Investment deposits are accepted for a predetermined or indefinite period of time and the investors consent in advance to allocate the profit (or loss) in an agreed proportion with the bank. Capital is not assured. (Ghafoor, 1995).
Some IFIs (Islamic Financial Institutions) classify deposits in terms of wadiah or amanah. Current accounts of IFIs are regarded as Qard-al-hasana or Qard (alternatively, as Wadiah/Amanah). (Farooq, 2008). Qard al-Hasana is defined as deposits whose full repayment on demand is guaranteed by bank. (Ahmad, 1994). The deposits in the current account are regarded as if they are loans from the customers to the bank and thus, bear no profit to the account holders. (Al-Jarhi and Iqbal, 2001). Deposit accounts are neither a liability nor equity capital. They are a "hybrid" source of capital, and must be acknowledged as such. Depositors are partners with the bank, but enjoy no ownership rights. (Shubber and Alzafri, 2008).
Sudin Haron (1996) mentioned that law allows banks to accept two kinds of deposits, i.e., Qard al-hasana deposits & term investment deposits. The Qard-al-hasana deposits includes current as well as savings accounts which vary in their operational rules. (Ahmad, 1994). If it is allowed that the borrower can pay extra money voluntarily, then treating deposits as Qard-al-hasana allows the banks as borrowers to pay extra money to depositors (lenders). Unlike savings account services at conventional banks, where depositors are rewarded upon appointment of their funds, returns to savings account holders are reliant on the Shariah principles which are practiced by Islamic banks when offering this service. When Wadiah or Qard-al-hasana are used, the returns are completely at the discretion of banks. (Sudin Haron, 1996).
Nienhaus, (2004) argued that if the customers of Islamic banks desire a return on their funds, they should deposit into investment accounts also called participation accounts or PLS, profit & loss sharing accounts. Whereas, credit balances on these accounts are not considered deposits in the conventional sense. The returns on Islamic banks' investment accounts are not fixed in advance; the customers participate by a certain proportion in the financial outcome of the utilization of their investment money by the bank. These results can also result in a loss. In case of loss, the clients will have to bear a portion of the loss which would lessen the nominal worth of credit balances of their respective investment accounts. In such a situation, the clients cannot claim a full reimbursement of the money paid in. The full reimbursement, however, is essential for a deposit in strict sense. (Nienhaus, 2004).
Rosly and Zaini, (2008) said that the public in general put their money in banks for either fulfilling transactional needs or for investment needs. To suffice the transactional objective, Islamic banks offer services such as Wadiah-yad-dhamanah deposit, which facilitates safekeeping of their deposit money with guarantee services. In this product, depositors no longer deposit funds to receive a fixed income. Instead, they place their deposits for protection. Wadiah yad dhamanah means safekeeping with guarantee. Wadiah yad dhamanah depositors permit the Islamic bank to invest their money in return for deposit safety that they got for free. Since the caretaker service is given without a fee, the Islamic bank holds no legal compulsion to pay depositors a predetermined return and may do so only on voluntary basis. In this way, the bank holds choice on profit distribution policy in the form of gift (Hibah). The same is not correct for Islamic fixed deposits, frequently known as Mudarabah investment deposits. In this partnership composition, no guarantee is given to capital protection and fixed income, as it runs under equity principle. It is a precarious product as the underlying contract is based on profit-loss sharing system. Profits are shared only in case of performing investments, while capital may depreciate or even shrink if the investment ends in losses. (Rosly and Zaini, 2008).
Haron and Azmi, (2004) discussed that similar to conventional banks, Islamic banks also rely on depositors' money as a key source of fund. Bank Muamalat Malaysia Berhad for example, had entire deposits amounting to 94 percent of total liabilities and shareholders' equity at the end of December 2003. This revealed the vast high total of the depositors' money as a supply of finance for Islamic banks. Hence, it becomes indispensable for the management of Islamic banks to identify the factors that are most likely to convince customers' decision making in depositing their capital with Islamic banks. (Haron and Azmi, 2004).
With the exception of a study done by Metawa and Almossawi (1998) where religion was seen as a reason influencing customers' choice to support Islamic banks in Bahrain, other studies have proven counter wise. The evidence from studies done in Sudan and Turkey, for example, revealed that religion was not the main motive for customers choosing Islamic banks (Erol and El-Bdour, 1989). Likewise, studies conducted in Malaysia and Singapore revealed both religion and profit as the explanation for people maintaining their association with Islamic banks (Haron, 1994 & Gerrad and Cunningham, 1997). As depositors are attracted by profits, it is vital for Islamic banks management to be aware of the fact that return rates on deposits persuade their customers' decision to deposit. (Haron and Azmi, 2004).
Relating to commercial banks' deposit composition, Hester and Zoellner (1966) and Heggested (1977) found that time and savings deposits had a significant inverse correlation with profitability. Smirlock's (1985) findings demonstrated a significant positive relationship amid demand deposits and profits. In contrast, Fraser and Rose (1971) found that loan rate; time deposit rate and loan-to-deposit ratio had no outcome on profitability. Haron (1996a) found evidence to suggest that current, savings and investment accounts of Islamic banks are positively related to profitability. Fraser et al (1974) considered operating costs, deposit and loan structures as factors within the control of management and found that the factor which had the biggest control on bank performance was bank cost followed by bank's deposit and loan composition.
Heggested (1977) proved that banks heavily devoted to time and savings deposits earned considerably lower returns than banks which have higher reliance on demand deposits. Smirlock (1985) confirmed that demand deposits were a cheaper source of funds and had a positive impact on bank profits.
In the literature, the majority of studies found that savings and time deposits have a negative relationship with profitability, while a positive relationship has been found for current account deposits. Haron (2004) found that nearly all deposit structure variables had no significant relationship with the profitability ratios. Deposits in current account, was the sole variable which possessed a significant relationship with Bank's portion of income as a percentage of total assets and Net profit before tax as a percentage of total assets. Each 1% increase in the current account holdings increased the bank's income by 0.034% and profit before tax by 0.036%. This end result was in line with the findings reported by Smirlock (1985). Since a current account service is considered a cost-free facility, it is anticipated that the more funds deposited into this account, the more Islamic banks would stand to profit. Interestingly, no significant relationship was found between current account deposits and Total income as a percentage of total assets, which implied that an increase in current accounts does not generate more proceeds to the bank as a whole but only functions as a cost saving measure. That is, no returns are paid to these depositors. In the case of savings and investment accounts, even though their relationships with all profitability ratios were at an insignificant level, the signs of their regression coefficients warranted further clarification. No contradiction with the findings of conventional banking literature with regard to savings accounts was apparent. A negative relationship was found between Savings account deposits and the profitability measures. This result suggested that any increase in savings accounts reduced profits and it corresponded to the findings in the current banking literature. For example Hester and Zoellner, (1966) and Heggested, (1977).
The results on Investment account deposits in Haron's (2004) study were not similar to those findings reported in earlier researches. Hester and Zoellner (1966) and Heggested (1977), for example, found that fixed deposit facilities had an inverse relationship with profitability. Since some of the characteristics of investment deposits at Islamic banks were similar to the fixed deposit facilities of conventional banks, it was expected that more funds deposited into these accounts resulted in less profit to the bank. In contrast, Smirlock (1985) believed that an increasing amount in fixed deposits had a positive relationship with the bank's profitability. Haron (2004) found that Investment account deposits had a positive relationship with all profitability measures and thus confirmed Smirlock's hypothesis.
Haron and Azmi (2004) attempted to investigate the strength of influence between both internal and external variables and profitability of Islamic banks in selected countries using time-series techniques of co-integration and error-correction mechanism. They found a significant long-run relationship amid Islamic banks' profitability measures and determining variables such as liquidity, deposit items, assets structure, inflation and money supply. They also found that Investment account deposits was the solitary variable which possessed a significant relationship with all three profitability ratios. For Current account deposits, a positive relationship was found with Bank's portion of income as a percentage of total assets. The result indicated that a 1% increase in current account holdings increased the bank's portion of income by 0.064%. Interestingly, current account deposits had no significant relationship with Total income as a percentage of total assets implying that an increase in current accounts did not generate more income to the bank, but only functioned as a cost saving measure. On other words, Islamic banks do not pay any rewards to their depositors. These results were in line with the findings of Haron (1996a, 2004). Savings deposits variable was found to have a significant positive relationship with Total income as a percentage of total assets. For every 1% rise in savings account, total income increased by 0.26%. This was in line with normal banking practices whereby Islamic bank used the funds deposited in this account for productive purposes and thus, generated additional revenue for the bank.
Shubber and Alzafri, (2008) found that increases in deposits size had a positive impact on Earnings per share (EPS), as a portion of depositors' profits is charged as a fee for the benefit of the bank and its shareholders. Returns on Islamic deposits were though flexible in nature since returns were based on performance rather than contracted upfront as evident in all interest bearing deposits. Although the mudarabah rates (investment deposit rates) were quoted using the rates given in the previous months, they were not fixed beforehand and served as an indicative rate of return on Mudarabah deposits (ROMD). The Mudarabah (investment deposits) contract worked along profit-loss sharing principles while fixed deposits of conventional banks were based on the contract of debt. As an equity product, a Mudarabah deposit offered no principal protection and legal claims against any form of returns. To make up for the risk exposure of the product, Mudarabah depositors were expected to be given higher returns relative to that of commercial banks' fixed depositors who avoided risk. (Rosly and Zaini, 2008).
Haron and Shanmugam (1995) tried to link the profit rates to Islamic bank's deposits. Using First Order Autoregressive model and Pearson Correlation, they established strong negative relationship between the two variables. Likewise, their finding showed a positive linear relationship between conventional and Islamic bank deposits.
Haron and Ahmed (2000) argued that people who invested their deposits in saving and investment account facilities were inspired by profit motive. The utility maximization theory amongst the muslim customers was further established by the negative relationship amid the rate of interest in conventional banks and the sum deposited in interest-free deposit facilities. Muslims should be inspired by Islamic doctrines when making economic decisions. Therefore, role of educating people regarding Islamic banking system should be played globally. It is indeed a challenging task. (Haron and Ahmed, 2000).
Shubber and Alzafri, (2008) said that EPS (Earnings per share) improved as the level of deposits increased, as depositors were viewed as sharers in the profit and loss, rather than being entitled to a fixed interest rate. This supported that increasing deposits had a positive impact on EPS (Earnings per share). Increasing deposits, therefore, did not direct any increment in the cost of equity. In fact, equity holders benefited from larger deposits, as owners of the latter pay out management fees, which is deducted from the depositors' share of the profits. Furthermore, the Islamic banks' market value is independent of WACC. (Shubber and Alzafri,2008).
Haron and Azmi (2004a) demonstrated that with the exception of fixed and investment deposits, any increase in rates of interest, increased the deposits at conventional system but decreased deposits at the Islamic system, and vice-versa. As for the fixed and investment deposits, ambiguous results were found. One possible explanation for this was that rates of profit for deposits at Islamic system were known at the end of the deposit period and not at the beginning as opposed to the conventional system. Any upward changes in interest rate of conventional system had an adverse impact to the deposit levels in the Islamic system. The religious dimension was considered as an important element to attract more people to deposit their funds in the Islamic system. This was the reason why more and more conventional banks started to offer Islamic banking facilities to their customers not only in Malaysia but also to other parts of the world. (Haron and Azmi, 2004a).
Hasan and Bashir (2003) argued that the rising contest and continuous innovation to provide financial services, all contributed to an increasing concern in the detailed evaluation of Islamic banks. Depositors were interested in evaluating the performance of their banks since they were not given fixed returns and the nominal values of their deposits were not assured. In trying to make best use of the value of shareholders' investment, Islamic banks were exposed to risks. Hence, analyzing the Islamic banks' performance is important from economic and public policy perspective. (Hasan and Bashir, 2003).
CHAPTER 3:
RESEARCH METHODS
3.1 Method of Data Collection
The data for this study was time series data taken from the quarterly editions of the "Islamic banking bulletin" published by the State Bank of Pakistan. These bulletins publish the consolidated financial statement variables representing the entire Islamic banking industry of Pakistan including all the full fledge Islamic banks (Al Baraka Islamic bank, Bank Islami Pakistan limited, Dawood Islamic bank Limited, Dubai Islamic bank limited, Emirates Global Islamic bank Ltd and Meezan Bank Ltd.) as well as the Islamic branches of conventional banks (Askari Bank Limited, Bank Al Falah Ltd., Bank Al Habib, Faysal Bank, Habib Metropolitan bank, MCB Bank Ltd, National bank of Pakistan, Soneri Bank Ltd, Standard Chartered Bank, The Bank of Khyber, Royal bank of Scotland, United Bank Ltd).
3.2 Sample size
The sample period for this study was limited from 2007 to 2010 as most of the Islamic banks started operations from 2007 in Pakistan. Hence, the consolidated data of the thirteen quarters was used in this study.
3.3 Research Model developed
The general equation of the model is:
Profitability = b0 + b1(ID)
Where,
b0 = intercept (constant)
Dependent variable:
Profitability = ROE (Return on Equity)
Independent variable:
ID = Investment Deposits
3.4 Statistical Technique
Most of the previous research used regression analysis technique in measuring the relationship among the determining factors and profitability ratios. Extending the previous work in Islamic banks' performance, this thesis examined the strength of relationship between Investment deposit variable and profitability of Islamic banks using univariate regression methodology. Univariate regression is a method of regression analysis that uses one explanatory variable to predict values of a single dependent variable. SPSS software was applied to obtain the univariate regression. In this study, the independent variable titled "Investment deposits" was used. The dependent variable of profitability was measured by ROE which is the ratio of a bank's net after-tax income divided by its total equity capital. The return on equity (ROE) is known to be one of the profitability performance ratios (Tarawneh, 2006). ROE indicates how effectively the management of the bank is able to turn shareholders' funds (i.e. equity) into net profit. ROE (Return on Equity) was tested separately with the independent investment deposit variable to avoid the issue of multicollinearity since all the deposit variables are highly correlated to each other.
CHAPTER 4:
RESULTS
4.1 Findings and Interpretation of results
The results of the univariate regression analysis for the research model are shown in Tables 1, 2 and 3.
Table 1 titled Model summary provides the R values for assessing the overall fit of the model. The value of the adjusted coefficient of determination (adjusted R2) for ROE in the model was 0.38 which demonstrated that 38% of the variability in total is explained by ROE's linear association with the Investment deposits variable. A relatively small value of adjusted R2 does not necessarily mean that the model is inappropriate to measure the relationship between independent and dependent variables. (Haron, 2004).The value of adjusted R2 is usually influenced by a number of predictive variables relative to the sample size and it becomes smaller as we have fewer observations per predictor variable (Hair et al., 1995). To provide a rationale for the variance in R2 and adjusted R2 values, the Durbin-Watson test was conducted. The Dublin-Walter statistics value was less than two which proved that the variance was due to negative autocorrelation in the sample observations.
Table 2 presents the ANOVA statistics. The adequacy of a model for predicting is validated by the F-test. (Haron, 2004). As presented in the table, the F-ratio value was statistically significant at 5% significance level for the research model. Hence, the results confirmed that the model applied was useful for measuring the relationship between investment deposits variable and the profitability variable.
Table 3 provides the regression coefficients with the significance level. The regression equation for the research model is:
ROE = 3.64 +0.023(Investment Deposits)
The significance value for the beta coefficient of Investment deposits was 0.025 which means that the result was significant at 5% significance level. The regression equation showed that an increase of each one billion rupees will increase the ROE value by 0.023%. The results supported the hypothesis that Investment account deposits increase the profitability of Islamic banks. This result is in line with Haron (1996a, 2004) who founded evidence to suggest that all three sources of funds (current, savings and investment accounts) for Islamic banks are positively related to profitability.
The Hypothesis of this study suggested that investment deposits increase the profitability of Islamic banks. The results show that the value of the adjusted coefficient of determination (adjusted R2) for ROE in model.1 is 0.4 which demonstrates that 40% of the variability in total is explained by its linear association with investment deposits variable. Hence, results supported the hypothesis.
4.2 Hypothesis Assessment Summary
Table 1. Model Summary
Model
R
R Square
Adjusted R Square
Std. Error of the Estimate
Durbin-Watson
1
.616a
.380
.323
.88904
1.342
a. Predictors: (Constant), Investment Deposits(Rs. In billion)
b. Dependent Variable: ROE after tax (%)
Table 2. ANOVA
Model
Sum of Squares
df
Mean Square
F
Sig.
1
Regression
5.320
1
5.320
6.731
.025a
Residual
8.694
11
.790
Total
14.015
12
a. Predictors: (Constant), Investment Deposits(Rs. In billion)
b. Dependent Variable: ROE after tax (%)
Table 3. Regression Coefficients
Model
Unstandardized Coefficients
Standardized Coefficients
t
Sig.
B
Std. Error
Beta
1
(Constant)
3.640
.687
5.295
.000
Investment Deposits(Rs. In billion)
.023
.009
.616
2.594
.025
a. Dependent Variable: ROE after tax (%)
CHAPTER 5:
DISCUSSION, IMPLICATIONS, FUTURE RESEARCH AND CONCLUSION,
5.1 Discussion
Referring to previous literature, the results were mixed. In the literature, most studies found that savings and investment deposits had an inverse relationship with profitability, while a positive relationship had been found for current account deposits
The results on investment deposits in this study are not similar to most of the findings reported in commercial banking literature. For example, Hester and Zoellner (1966) and Heggested (1977) found that fixed deposit facilities had an inverse relationship with profitability. In contrast, Smirlock (1985), Haron (1996a, 2004), Haron and Azmi (2004) believed that an increasing amount in fixed or investment deposits had a positive relationship with a bank's profitability. This thesis found that investment deposits had a positive relationship with the profitability measure and thus, confirmed Smirlock's, Haron's and Azmi's hypothesis.
In light of the above findings, Islamic banking provides a better and ethical alternative that is not only Riba-free according to the rules of Shariah but also profitable to depositors and investors.
5.2 Implications and Recommendations
Since, Islamic banking provides three different interest-free deposit facilities to its depositors and investors to facilitate them according to their financial needs, people should invest in these deposit accounts in order to patronize the Islamic banking industry and to receive good returns in the form of "hiba" from the Islamic banks.
In addition, Ghazali (2008) suggested that Islamic banking is indeed relevant to the current economic crisis. The global financial and economic recession originating from the US actually poses an opportunity for the Islamic banking system to demonstrate its distinctiveness. The financial meltdown revealed a desperate need for a structure like Islamic finance, based on the belief of profit sharing where both the parties are subjected to probable losses and returns. It is a fair and just system. This is contrasting to the conventional system as Islamic banks do not acquire or trade debt, rather they manage substantial assets which are linked to socio-economic activities.. This is really an opportunity for the Islamic financial community to reveal to the international market that Islamic financial system is actually a robust and feasible alternative to the conventional interest-based system.
5.3 Future Research
This study can be extended to include more time series and cross-sectional data of Islamic banks of other countries. The study may also be extended to cover other determinants of Islamic banking profitability.
5.4 Conclusion
Hence, people should support the Islamic banking industry worldwide since investment deposits are positively related to the profitability of Islamic banks. Hence, increased deposits would result in higher profitability of Islamic banks which in return would provide higher returns to its depositors. This would finally lead to implement a justified and ethical economic system which encourages a fair distribution of wealth and resources throughout the society.
