finance

The finance essay below has been submitted to us by a student in order to help you with your studies.

Deposits Profitabilty Relationship Of Islamic Banks Finance Essay

The purpose of this research study is to analyze the impact of Islamic Banking Deposits (Investment, Savings and Current accounts) on the profitability measure ROE of the Islamic banking industry in Paksitan. For this purpose, time series data of eleven quarters covering the period 2007 to 2009 is taken for the required variables from State Bank of Pakistan’s quarterly editions of the ‘Islamic banking bulletin’. The results showed that all the deposit variables had significant positive relation with Islamic banks’ profitability. The aim is to contribute to the literature on deposit-profitability relationship of Islamic banks.

Assessing Deposits-Profitability Relationship of Islamic Banking industry in Pakistan

Introduction

Islamic banking is a banking activity based on Islamic principles, which do not allow the paying and receiving of interest (riba’) and promotes profit sharing in the conduct of banking business. (Ghazali, 2008). 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. State Bank of Pakistan’s strategic plan for the Islamic banking industry launched in 2008 in Pakistan, aims to increase the size of this industry to 12.0 percent of 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. Seeing the potential of the Islamic market, western conventional-based financial institutions such as Citibank, JP Morgan, Deutsche Bank, ABN Amro and American Express have introduced interest-free products to customers. Similarly, multinational corporations such as General Motors, IBM and Dewoo Corporation have already begun to use interest-free services.(Haron and Azmi, 2003).

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 paper examines the strength of relationship between deposit variables and profitability of Islamic banks using univariate regression methodology. By studying the association between Islamic banks’‟ performance and the deposit variables, this paper contributes to the on-going discussion on the deposits and profitability relationship of Islamic banks.

The paper is divided into seven sections. The literature review on determinants of Islamic bank performance is highlighted in Section 2. Section 3 examines the methodology used in analyzing the relationship between the deposits variables used in this study and the performance of Islamic banks. Section 4 presents the discussion and implication. The references are listed in section 5. The tables are listed in section 6 and figures in section 7.

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) states that all Islamic banks possess three types of deposit accounts: current, savings and investment. Current or demand deposit accounts are nearly the same as in all the conventional banks. Deposit 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 and minimum balance. Capital 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 hasan 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) mentions that law allows banks to accept two kinds of deposits, i.e., qard al-hasanah deposits & term investment deposits. The qard al-hasanah 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-hasan 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 hassan are used, the returns are completely at the discretion of banks. (Sudin Haron, 1996).

Nienhaus, (2004) argues 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) say 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) discuss 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 total deposits amounting to 94 percent of total liabilities and shareholders’ equity at the end of December 2003. While in the case of Jordan Islamic Bank, Islamic Bank of Bangladesh, Bank Muamalat of Indonesia, and Bank Shariah Mandiri of Indonesia, the corresponding amounts were 94%, 86%, 76%, and 79%, respectively. These figures reveal 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 et al., 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 only variable which had 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 suggests that any increase in savings accounts will reduce profits and it corresponds to the findings in the current banking literature (see for example Hester and Zoellner, 1966; and Heggested, 1977).

The results on Investment account deposits in Haron’s (2004) study are 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 are similar to the fixed deposit facilities of conventional banks, it is expected that more funds deposited into these accounts would result in less profit to the bank. In contrast, Smirlock (1985) believed that an increasing amount in fixed deposits would have a positive relationship with a bank’s profitability. Haron’s (2004) study 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 timeseries techniques of cointegration and error-correction mechanism. They found a significant long-run relationship between profitability measures of Islamic banks and determining variables such as liquidity, deposit items, assets structure, inflation and money supply. They also found that ‘Investment account deposits’ was the only variable which had 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%. Given that current account facility is a cost-free service, the more funds deposited into this account, the higher profits will be made available to Islamic banks. Interestingly, current account deposits had no significant relationship with ‘Total income as a percentage of total assets’ implying that an increase in current accounts does not generate more income to the bank, but only functions 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 could use the funds deposited in this account for productive purposes and thus, generating additional revenue for the bank.

Increases in deposits size has a positive impact on Earnings per share (EPS), as a portion of depositors’ profits is minused as a fee for the benefit of the bank and its shareholders. (Shubber and Alzafri, 2008). Returns on Islamic deposits are though flexible in nature since


Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay


More from UK Essays