What determines the profitability of Islamic banks: Lending or fee?

https://doi.org/10.1016/j.iref.2019.05.015Get rights and content

Highlights

  • This paper investigates the role of loan to deposit ratio and fee income on bank performance.

  • The paper builds a theoretical model for Islamic bank in which fee has dominant role than lending.

  • Empirical results show that lending enhances conventional banks performance.

  • Analysis also shows that fee-based income enhances Islamic bank's profitability.

Abstract

This paper analyses the effect of bank lending and fee income on Islamic and conventional bank's performance. The paper builds a theoretical model and provides empirical evidence to show that Islamic banks as compared to conventional banks can have a greater reliance on fee-based income than returns from loans to increase their profitability. Using data from a sample of 20 countries for the period from 2000 to 2015 for Islamic and conventional banks, we find that the bank fee is an important determinant of the profitability of an Islamic bank. Interestingly, many commonly used measures such as loan to deposit ratio do not affect the Islamic banks' profitability as much as they do for conventional banks. Our findings imply that Islamic banks' lower sensitivity to loan to deposit ratio may contribute to lower credit risk. However, an over-reliance on fee-based income may affect their growth, profitability and sustainability in the long run.

Introduction

Islamic banking literature has grown rapidly in the last decade, fuelled by the success of the Islamic finance industry. The existing literature has examined different aspects of the industry including risk, performance, efficiency and stability of Islamic banking in contrast to conventional banking (see Abedifar, Molyneux & Tarazi, 2013; Beck, Demigruc-Kunt & Merrouche, 2013; Abedifar et al., 2015 and Hassan & Aliyu, 2018).1 In spite of the surge in the literature, there are still some puzzling issues on the determinants, which may affect Islamic banking performance differently from conventional banks. In this paper, we offer theoretical and empirical evidence that there are two determinants, in particular, fee income2 and loan to deposit ratio,3 which may affect Islamic and conventional banks differently.

Several prior studies on conventional banks find the importance of fee income to bank profitability (see, for instance, Demirgüç-Kunt & Huizinga, 1999; Stiroh, 2004; Lepetit, Nys, Rous, & Tarazi, 2008 and Maudos & Solís, 2009). Demirgüç-Kunt and Huizinga (1999) present the empirical evidence that banks in Eastern Europe relied heavily on fee-based operations in the early stages of their growth. Lepetit et al. (2008) report that in the 1980s, the US commercial banks' share of fee-based income represented 19% of total income, which had increased to as much as 43% in 2001 (Stiroh, 2004). Recently Ariss (2010), Beck, Demigruc-Kunt and Merrouche (2013) and Bourkhis and Nabi (2013) have compared fee income and loan to deposit ratio for Islamic banks vis-à-vis conventional banks.4 However, these studies have not thoroughly examined how fee-based income and loan to deposit ratio may affect the performance, profitability and risk of Islamic banks. We fill this research gap by examining the role of fee-based income as well as loans to deposit ratio on banks’ profitability after controlling for the market power and other bank-specific and macroeconomic variables.

Why fee-based income and loan to deposit ratio may affect Islamic banks differently requires further explanation. We argue that, as there are significant restrictions on the kind of lending arrangement an Islamic bank can use, they may have to rely on non-interest based arrangements involving fee income that complies with Islamic law. This should mean that every unit increase in fee income is expected to contribute more to an Islamic bank's profitability than that of a conventional bank. Moreover, given the limited number of asset side products that are available for dispersing the excess liquidity of Islamic banks, it may be that an increase in lending may put downward pressure on Islamic bank's profitability. Hence, in comparison to conventional banks, an increase in loan to deposit may be a less important determinant of profitability for an Islamic bank.

By emphasising loan to deposit ratio and fee-based income, we re-visit some puzzling issues of market power, piety premium, religiosity, risks and profitability in Islamic banking in comparison to its conventional counterparts. These aspects are important to investigate for a variety of reasons. First, while previous research (e.g., Abedifar et al., 2013) finds no evidence of piety premium, a recent study by Azad, Azmat, Chazi, and Ahsan (2018) detects that a piety premium is charged by Islamic banks. The argument to the piety premium is that Islamic banks bear higher risks than conventional banks because of lower economies of scale and Shariah compliance costs (Beck, Demirgüç-Kunt, & Merrouche, 2013). In this paper, we examine if, in the presence of a piety premium, Islamic banks’ higher lending to deposit ratio could affect its profitability.

Second, for about a decade beginning 2000, Islamic banks enjoyed a higher market power (measured by the Lerner Index, see Fig. 1) than their conventional counterparts as well as a piety premium for all the years since 2006, except for 2015 (see Fig. 3). During the same period, Islamic banks flourished at a rapid pace, growing at about 15%–20% per annum. Both the demand and supply side factors have contributed to the industry's growth, along with the increasing market power of Islamic banks. Particularly, the share of Islamic banks has increased because of the Shariah consciousness of its customers. Subsequently, loan to deposit ratio of Islamic banks have experienced a substantial increase compared to their conventional counterparts (see Fig. 2) in an environment fraught with higher market power, positive piety premium and lower loan defaults (e.g., Azad et al., 2018; Baele, Farooq, & Ongena, 2014). We argue in this paper that this increase in loan to deposit ratio may not have a significant impact on the performance of Islamic banks as it is found for conventional banks. This is due to their inefficiency (Beck, Demigruc-Kunt & Merrouche, 2013) or their inability to convert deposits into profitable lending because of religious constraints (Azmat, Skully, & Brown, 2015). In this paper, we find that both may be true. Moreover, Islamic banks might have adopted an alternative avenue, such as enhancing the fee-based income to improve the profitability, similar to the banks in Eastern Europe and the US as mentioned above. Hence, it is imperative to examine whether fee-based income improves Islamic banks' profitability.

Our theoretical and empirical settings proceed as follows. First, we build a theoretical model of Islamic bank intermediation, where the bank is taking funds from its religious customers who may experience some additional utility from depositing in an Islamic bank.5 We show that the optimal deposit rate offered by the Islamic bank depends on several factors including bank's risk, market power, macroeconomic risk and the customer's religiosity. Then the behaviour of customers on the asset side is examined. We assume that the customers can either borrow or be involved in a fee-based arrangement, both of which have to be compliant with Islamic finance law. An optimal rate of return on Islamic bank loans is then shown on the assumption of asymmetric information (hence, higher risk) and varied borrower qualities. We compute the Islamic bank's profitability function and demonstrate how the loan to deposit ratio may affect the bank's overall profitability. Our model shows that Islamic banks are most secured if they operate in an environment where there are a large number of quality religious borrowers and in an environment fraught with risk and information asymmetry, they are better off using fee-based transactions to improve their profitability.6

We examine our theoretical propositions using the annual data from a sample of 20 countries for the period from 2000 to 2015 for Islamic and conventional banks. Controlling for firm and year fixed effects, we find, in line with our hypotheses, that for Islamic banks, there exists an insignificant and (or negatively significant) relationship between loan to deposit ratio (LDR) and net interest income margin (NIM).

In contrast, we find that the loan to deposit ratio is a significantly positive determinant of conventional bank's NIM. When we test for the impact of LDR on another performance measure, namely interest expense margin (IEM), we find that LDR positively affects the Islamic bank's IEM and negatively affects conventional bank's IEM. We then test for the impact of fee-based income on Islamic and conventional bank's profitability. In line with our theoretical model, we find that the fee-based income has a significantly positive impact on the profitability of Islamic bank (NIM), while the effect is insignificant for conventional banks. Lastly, we test the sensitivity of fee and LDR relationships with IEM/NIM during the periods when Islamic banks enjoyed greater market power, positive piety premium and higher loan to deposit ratio. Results remain the same and are robust to various sub-sample analyses as well as to alternative econometric specifications. We thus contribute to the literature on the determinants of the Islamic bank's profitability by offering theoretical and empirical insights into how loan to deposit ratio and fee income may affect the profitability of Islamic and conventional banks differently.

Our findings have important implications for Islamic banks and regulator. We suggest that Islamic banks should improve their liquidity management by designing new financing products on the asset side as the over-reliance on fee-based income may threaten their long-term profitability and stability. For regulators, our results suggest that Islamic banks can be less risky and more stable than conventional banks as they are less sensitive to changes in the loan to deposit ratio.

The rest of the paper is structured as follows. Section 2 discusses the model. The data and methodology are described in Section 3. Section 4 discusses the results. Section 5 concludes the paper.

Section snippets

The model

In this section, we present a model for an Islamic bank to understand the impact of different determinants on their profitability. We are particularly interested in the impact of the loan to deposit ratio, fee-based asset side transactions, market power, efficiency, risk and religiosity on Islamic bank's profitability. In terms of the basic setup, our model is closest to Ueda (2004) and Azmat et al. (2015). We build a two-period model, where the Islamic bank interacts with the depositors and

Data and methodology

We use a dataset covering a large sample of countries where both Islamic and conventional banks co-exist. The analysis includes countries with data on at least four banks for a minimum of two-year observations. We remove outliers in all variables by winsorizing them at the 1st and 99th percentiles within each country. This eventually leaves us with the data that covers the period from 2000 to 2015 for 20 Muslim-majority countries. We allow banks to enter and exit during the sample period. After

Summary statistics and correlation matrix

Table 1 presents the summary statistics of Islamic and conventional banks. The average net interest margin (NIM) of Islamic banks is much higher than that of conventional banks; the average interest expense margin (IEM) is same for both Islamic and conventional banks. A higher NIM of Islamic bank for a given level of IEM implies that Islamic bank charges a piety premium.

Among the explanatory variables of our interest, the average loan-to-deposit ratio is higher for Islamic banks (104.64) than

Conclusion

In this paper, we study how the process of intermediation can be different in Islamic and conventional banks. Specifically, we show how lending and non-lending (fee-based income) activities of banks play different roles in conventional and Islamic banks. By so doing, we contribute to the literature on the determinants of the Islamic bank's profitability by offering theoretical and empirical insights into how loan to deposit ratio and fee income may affect the profitability of Islamic and

Acknowledgement

We thank the Editor, Guest Editor and two anonymous referees for valuable comments and suggestions, which greatly improved the quality of our paper. All remaining errors and misinterpretations are ours.

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